We are indeed happy to have moved forward to a process-based approach in introducing you to an interesting introspection in to your own behavioral assessment. As you know, behavior plays a very crucial role in the investment arena, hence, understanding yourself better will help you move in the right direction.

Here, know Thyself intended to understand

a) Risk Required

b) Risk Capacity.

So, Risk Profiling is a process for finding the optimal level of investment risk for you, by balancing your Risk Required, Risk Capacity and Risk Tolerance.

a) Risk Tolerance is the level of financial risk you are emotionally comfortable.

b) Risk Required is the risk associated with the return required to achieve your financial goal from the financial resources available.

c) Risk Capacity is the level of financial risk you can afford to take.

In finance, risk is the probability that actual results will differ from expected results. Risk takes on many forms but is broadly categorized as the chance an outcome or investment’s actual gain will differ from the expected outcome. In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects / implications of an activity with respect to something that humans value, often focusing on negative, undesirable consequences. From financial market perspective when most investors think about investing, they first think about risk. While the financial markets and experts define risk as a mathematical number (e.g. volatility), common investors think of risk as possibility of losing their investment (fully or in parts) or making less than expected returns.

Risk Profiling is a process of estimating the risk-taking capacity and willingness to take risk. It helps an investor understand how much risk they can take vs how much risk they should take to achieve their goals. We do this by asking the investor a set of simple questions that help us to determine investor’s investment goals, risk appetite, investment horizon, etc. This also helps us investor to choose right investment schemes based on your Risk Assessment and the Riskometer of that particular Mutual Fund schemes and other financial products. Also help us to design right asset allocation.

Risk profiling involves assessment on four fronts:

• Risk capacity: This is also called Risk Appetite, level of financial risk that an investor can manage comfortably based on his life situation (e.g. risk capacity will be higher for a young salaried investor vs a middle aged man with two children). This is more a psychological factor.
• Attitude to risk: Investor understanding of the concept of risk and how it applies to their financial life.
• Risk tolerance: Investor’s ability to cope at psychological level with the volatility of capital markets. (e.g., response/reaction towards market corrections.) It can vary with age, income, responsibilities, etc.
• Risk requirement: Investor’s financial goals to understand where they

Investors make investments in order to achieve certain financial goals.

Risk profiling helps investors understand how much risk they are able and willing to take and thereby helps them make appropriate investments matching their risk profile.

Everyone calls investments, especially in the stock markets, ‘risky’. “The market is too risky to invest now”, “You must know your risk appetite before starting”, “I can’t risk my money” are some very commonly overheard statements in the investing circles. Ask them what risk is, and the earth moves from under their feet.
In the simplest of terms, risk is the possibility of something bad happening. It involves an air of uncertainty in the expectation of outcome because of an activity, or inactivity, around something that we value. It is just unfortunate that it has come to be associated with negative and undesirable consequences. This gives cold feet to many and prevents them from even trying.

In finance, calculated risk gains precedence. Remember, “all investments are subject to market risk” (You did re-read that line super-fast like in the ads, didn’t you?) Well, that is the truth. Although the levels vary, all investments feature some degree of risk. Therefore, it becomes essential to understand your risk profile before you dive into the game.

Will you go out for ice cream when you have a sore throat? No, you wouldn’t because you don’t want to risk it worsening your health. Similarly, understanding your financial risk profile helps to know which investment products and approach is appropriate or suits you. It helps an investor find the optimum level of risk that he or she can take to buffer from an unforeseen fall. And this further helps investors determine the asset classes (equity, debt, gold, etc.) and the style of investment they are comfortable with (growth, value, etc.).

Investors are required to take a short assessment to answer questions about their goals, attitude towards risk, demography, etc. It is a common practice to evaluate risk based on the financial standing of investors. If you happen to have more assets than liabilities, you are assumed to likely be a risk-seeker. Somebody with enough wealth for retirement and no loans may also come under this category. This is because such investors are unlikely to be affected much by the short-term vagaries of the market. The risk profile depends a lot on the psychology of the investor and his opinion of risk too.

Factors influencing a risk profile:

Here are a few factors other than the Asset-Liability and Income-Expenditure that have a bearing on risk profile:

1. Age
A young investor with minimal responsibilities can think of putting more money into riskier investments. A family-man may need a different approach, and someone nearing retirement may best approach investing conservatively.

2. Income
If you have a regular, stable income to support your lifestyle and your future prospects are bright, you can consider taking a higher risk when investing to earn higher returns.

3. Investment Horizon
If your financial goal is far out, you can afford to take risks now as you have the opportunity to ride out short-term fluctuations in the market by staying invested for a longer duration.

4. Emergency Fund
It is recommended to have at least 6-8 months of expenses, including EMI, for contingencies. Having a sufficient corpus will allow you to take more risks in investing.

5. Insurance
It is mandatory to have adequate life insurance before you start taking risks with your money. A health cover helps avoid dipping into your savings in cases of medical emergencies.

6. Family Wealth
Surplus money that you can put to good use and earn more can be invested in riskier instruments. However, if a loss of that wealth will stretch your finances, it is better to invest conservatively.

7. Experience
Investors who have made successful investments are generally comfortable taking higher risks than someone who has made losses, or is a beginner.

8. Knowledge
This is the best investment one can make. Your understanding of a financial product and how the markets work determines your willingness to take risks. The higher your knowledge, the higher can be your risk appetite and vice-versa.

Take this with a pinch of salt: No matter how fit and prepared millennials believe they are, age (and maturity) catches up. You may go bungee jumping or skydiving now, but 30-40 years down the line, you may probably prefer to sip a cocktail by the beach than go parasailing.

Similarly, the risks you are willing to take with money at the age of 25 may not appeal to you at the age of 50. With changing priorities and responsibilities, your investment goals too are likely to change. It is important for an investor to be attuned to his/her risk profile so that a suitable asset allocation strategy can be worked out to help protect and grow your income through your life stages.

While risk appetite is a personal choice, risk tolerance is a little more complicated and involves a deeper analysis of the above-discussed factors and a lot more. For example, an investor may have low-risk capacity but high-risk tolerance, or vice-versa. What will his risk profile then be?

Let’s explore this with an example. Suppose you are driving a Merc out on the National Highway. You know that the machine can do 180-200km/hr, but what speed would you drive at? The speed you want to go at defines your risk appetite. It could be 40km/hr or even 200km/hr. Your risk tolerance is what speed you get to drive at, decided by various external factors. This would be a maximum 100km/hr, given the speed limit set by the Government of India.

Types of risk profiles and possible asset allocation strategies

Check out what kind of asset allocation may suit your risk profile.

1. Conservative
Investor Profile – A conservative investor is an individual who seeks stability when it comes to investing and is more concerned with protecting their capital than increasing its real value. As a result, they are normally willing to accept lower returns in exchange for capital preservation associated with short-term funds. This investor will have either a moderate time horizon or a slightly higher risk tolerance than the v. conservative investors.

Possible Asset Allocation – Mix of Fixed Income & Hybrid

2. Moderately Conservative
Investor Profile – A Moderately conservative investor is an individual who seeks stability when it comes to investing and is more concerned with protecting their capital than increasing its real value. As a result they are normally willing to accept lower returns in exchange for capital preservation associated with short-term funds. But when valuation in there favour then they are ready to take some risk.

Possible Asset Allocation – Mix of Fixed Income & Auto Allocation

3. Moderate
Investor Profile – A moderate portfolio is appropriate for an investor with a moderately high risk tolerance and a time horizon longer than 5 years. Moderate investors are willing to accept periods of moderate market volatility in exchange for the possibility of receiving returns that outpace inflation by a significant margin. They are willing to tolerate more fluctuations in exchange for more reasonable returns, but are still not comfortable enough with market risk to invest their funds aggressively.

Possible Asset Allocation – Mix of Fixed Income & Growth

4. Moderately Aggressive
Investor Profile – Moderately Aggressive investments are best for investors who aim for the highest possible return. However, they must have both a high-risk tolerance and a long time horizon. Moderately Aggressive investors are more drawn to higher levels of risk in exchange for higher levels of capital growth. When the valuation not in their favour they too parked temporarily in Fixed Asset. They are comfortable with volatility and fluctuations over the shorter to medium term.

Possible Asset Allocation – Mixed of Growth Asset and Auto Allocation

5. Aggressive
Investor Profile – Aggressive investments are best for investors who aim for the highest possible return. However, they must have both a high risk tolerance and long time horizon. A very aggressive portfolio may also be entirely composed of stocks. Aggressive investors are more drawn to higher levels of risk in exchange for higher levels of capital growth. They are comfortable with volatility and fluctuations over the shorter to medium term.

Possible Asset Allocation -Predominantly growth assets with Valuation

Conclusion:

Risk profiling is extremely useful irrespective of the investing stage you are at. A beginner can benefit from risk profiling as it helps set the right expectations and mirrors your aspirations and tolerance levels. This will help recognize your investment orientation, which is best done before you build your investment plan.

As you mature in the market and your personal goals change, so will your risk appetite. A risk profile analysis will help investors at that stage too to rebalance their portfolios and move investments around to suit their risk tolerance.

We highly advise periodic reassessment of your risk profile to keep your financial plan in sync with your time needs.