Why is Risk Profiling Important
While making investments a lot depends upon how much risk one is ready to take. Depending upon the risk appetite, the investor will make his/her decisions and build the portfolio accordingly. When you seek help from an investment advisor, your risk profile will be a significant defining criteria.
What is a Risk Profile?
A risk profile is an evaluation of an individual’s willingness and ability to take risks. It is important to determine proper investment-asset allocation for an individual’s portfolio keeping the risk profile as the base. The overall decision-making strategy will rest upon how much risk the investor wants to take. This risk should be considered against the possible returns. The investor might prefer not to achieve capital appreciation because of the risks involved; such an investor is called risk averse. On the contrary, if the investor is ready to face volatility or market fluctuations in order to earn maximum possible returns, he is known as a risk seeker.
The identification, quantification and assessment of risk is the basic process while planning an investment portfolio. Risk Profiling is a process which Advisers use to help decide the maximum levels of investment risk for clients. The goal is to define the risk required to meet a client-investor’s investment objectives keeping the risk taking capacity and risk tolerance levels in mind.
It is important to know about the three terms in this process: Risk required, Risk capacity and Risk tolerance.
- Risk required means the level of risk that one needs to take to attain the expected amount of returns from the investments made.
- Risk capacity is the level of investment risk that an investor can afford to take.
- Risk tolerance is the comfortable level of risk of any investor.
Again, evaluation can be done by reviewing an individual’s assets and liabilities. If the investor holds many assets and fewer liabilities then it shows his/her higher ability to digest risks. On the other hand if the investor possesses fewer assets as compared to the liabilities, the ability to take risk is apparently low. An individual who has set aside sufficient funds by way of retirement planning, insurance, emergency savings and other investments free of any claims naturally will not mind taking higher risks.
Risk tolerance Versus Risk Capacity
The willingness to take risks is different from risk taking capacity. Someone who is about to reach the investment target may not prefer a risky portfolio. An individual might take a risk averse approach when the desired mark is achieved and be content with whatever is already gained by investing them in low risk-return instruments exhibiting lesser risk tolerance.
Being financially viable sometimes results in more aggressive performance in the market considering the fact that the majority of required funds to live a comfortable life is already saved.
It all depends upon individual choices. The investor may or may not take the aggressive approach.
Types of Risks
The financial market’s performance depends upon many factors. Risk is always present and it can be further divided as Systematic and Unsystematic risks.
Systematic risk is the influence of external factors on an investor about which an individual investor cannot do anything as those are out of his/her control. For example, foreign exchange risk, interest rate risk etc.
Unsystematic risks are the internal risks that one is exposed to but are under his/her control.
The approach based risk profiles of investors are as under:
- Conservative: Such an investor would not like to gain wealth appreciation at the cost of safety of capital. Prefers minimal risk and minimum or lower returns. The investors with a minimum two year timeframe prefer this type of allocation. They stick to fixed interest generating assets and invest a smaller proportion in growth assets. Possible allocation-Equity: 0-15%, Debt and others:85-100%.The major allocation tends towards cash and fixed interest bearing assets.
- Moderately conservative: Is someone who is ready to take a smaller amount of risk to earn returns over a medium to long term. These kinds of investors want to stay invested for a minimum period of three years. A lower level of investment value volatility is preferred. Possible allocation-Equity:10-30%, Debt and others:70-100%.
- Balanced: With a higher level of risk maximisation of returns is sought over a medium to long term.Minimum time frame is five years. Such investors like a modest level of capital stability but they also want to take moderate risks. Thus they agree to consider 50 percent exposure to growth assets. Possible allocation under this category-Equity: 0-50%, Debt and others:50-100%.
- Moderately Aggressive: A significant level of risk is taken to maximise return over a long period of time say seven years. Investors who prefer comparative higher levels of risks fall under this heading. They like a smaller portion to be invested in fixed interest generating assets and want to gain from market linked securities. Possible allocation-Equity: 0-70%, Debt and others: 70-100%.
- Aggressive: Aggressive investors are ready to stay invested for a minimum period of nine years. They want to take high levels of volatility and expect higher returns. 85% of the investments tend towards marked linked securities, property and infrastructure. And 15% is allocated towards safer investments.
- Very aggressive:These investors prefer very high levels of returns against highest levels of risks. 100 percent of their money gets invested into growth assets. The main goal of these investors is profit optimization and they do not consider capital stability at all as part of their investment agenda.
Furthermore, the classification of an investor in any of the above categories might change over time. An individual’s earnings and other monetary matters like savings etc reflect on the financial choices made by him/her. Similarly what matters at a younger age might not be relevant when you cross an age of 40 or 50. Depending on such factors your risk appetite and potential return expectations might change and so will the approach. The finance/investment advisor will be able to help you based on the category you fall into.
How is Risk Profile Prepared?
The financial advisors and robo-advisors create the risk profile of investors with the help of questionnaires. The questionnaires are made to include both the numeric and objective data collected from individual investors as per their risk-appetite. There are choice based questions too which shall further condense the information gathered and help in sorting the funds according to risk-return determination. Overall it is a mixture of risk-return and also the period for which an individual wants to invest the money.
Many people do not know how to formulate the appropriate risk level that their portfolio should carry. The aim of this article is to make the readers clearly understand their risk-return philosophy and formulate their risk profiles accordingly. Whenever you invest your money into something, it is going to get exposed to risks. To compensate for that risk, you should be able to earn enough to protect you from the probable losses.
There are a few questions which might be helpful though by no means they are scientific yet the investors can use them while making their own portfolio. Even if you seek the help of an advisor, he too will gather some information from you by asking a few questions. Nobody can compel you to invest by compromising your basic necessities. On the one hand you are living your life, meeting all your ongoing expenses and on the other you are trying to save some money and let it grow by adopting a strategy. It gives immense satisfaction when your plans work and the invested amount turns into a sizable corpus. Your risk tolerance has a lot to do during this entire process and it is better to understand it if you are preparing your risk profile yourself. Instead of depending upon any bank or financial institute to do it for you, you can do it on your own. The questions that you should ask yourself are as under-
1. For how many years you are planning to invest and what are your financial goals? Time horizon and age have a direct relationship. If you start planning at a young age, there are many years left before you retire. The more the time, the more risks you can take. An average person starting early might learn more from the market fluctuations and may be able to make better decisions by altering his strategy from time to time. The financial goals also matter a lot. Unmarried investors in the early stages of their career can take more risks.
But if you start investing after a certain age, say 45, you might not be able to take more risks since your inclination will be more towards saving for your retirement savings and hence fixed but lower interest bearing securities which are safer to invest in.
At a young age you can take more risks, even if you lose, you will fill the gap in coming years. But at the age of 50 you cannot take more risk in absence of sufficient funds to support your life. Marriage, children, their education and dependent parents- all these put together will affect your risk taking abilities. One might not like to take many chances with more responsibilities and tend to be risk averse.
The tendency of a few investors is not to stay invested for a long time. Accordingly the risk return pattern will reflect in their portfolio. A long term investor will be able to take more risks and adjust to the market cycles. Those with a purpose to invest for their old age might not be ready to take more risks to go beyond this target. An individual with many financial goals will change the investing pattern to achieve the targets.
2. What will be your approach in a bullish/bearish market? When the markets are high, are you courageous enough to sell a part of your portfolio to book profits or not? An aggressive investor will make the most of a bullish trend. It is advisable to sell when the market is high. Similarly, when it falls it keeps on falling leading to a depressing scenario. However, as long as you stay invested, there are chances that you will gain in future. It’s better to buy when markets are low.
3. How many years are you going to earn and what are your retirement plans? If you have plans to retire early and start doing something on your own, you should consider the possibility of funds needed to finance your own venture and also take care of the pensionable years. Irrespective of the success from the activity that you undertake after early retirement, your golden years should not suffer. A more stringent plan to take care of everything will be needed. Setting aside funds to secure retirement life cannot be undermined.
Healthcare expenses increase when one becomes old. Insurance is a must to safeguard against hospitalisation. The monthly expenses incurred to run your life smoothly is a permanent phenomenon even during those times. You have to take care of your dependents throughout the lifetime as well as in old age. This has an impact on your risk tolerance. How much risk you are ready to take to generate sufficient funds for the future makes a difference.
4. How well do you understand the markets? It is important to understand the markets very well when you invest. It is possible that an investor is risk averse initially and chooses safer instruments to gain some confidence in the short term. If the investor remains active and tracks the market from time to time, the risk bearing capacity might increase and more market sensitive securities can get included in the portfolio.
Building a risk profile is as important as knowing the market sentiments. When both these key aspects are blended well, a well built portfolio can take shape. Balancing the risk with market knowledge is the crux of the story. Either you take responsibility or assign the task to some financial experts/advisors who are experienced in risk management. Remember with growing age, the time horizon to earn, save, invest and gain will decrease.
5.How many months of expenses do you need as emergency funds cover and how much can be invested? If you do not have any emergency funds, first of all you should set aside emergency funds sufficient to cover at least six months to a year’s expenses. Depending on what’s left, investments will follow based on a pre decided risk-return strategy. Liquidity is another aspect. If you have a short term target, invest according to how much return you want in the short time. Long term financial goals will be possible when sufficient emergency and liquid funds are already taken care of.
6. How many financially dependent members do you have in your family?A Smaller number of dependents means you might be able to save more or take higher risks. An unmarried young individual can definitely take higher risks and allocate more funds in different kinds of securities. An individual with more financially dependent members has to think more about fixed and stable returns and sufficient liquid funds to meet all types of emergencies. The risk taking capacity is obviously less.
7. How much risk are you ready to take in order to earn higher returns? In any given situation you should define how much risk you are ready to take to earn higher returns. Do you strongly agree, are being neutral, disagree or are strongly risk averse?
8. What will be the maximum surplus in your portfolio allocated into? This could be ranging from safer investments to high risk investments like fixed deposits, bonds, equities and derivatives, mutual funds and real estate. Choose which suits you the best.
9. What is your annual take home salary/income and how much of it goes into repaying your liabilities? Allocation of income against expenses/ liabilities will give a clear cut idea about the risk bearing capacity of an investor. This shows whether the assets could be more than the liabilities or vice versa.
Your risk profile should be flexible. As the factors affecting it may change based on several things including salary and disposable income. When you earn more, naturally you may turn into an aggressive investor. This being a strategic document to refer back to over time helps you to be on track while achieving your goals. When you hire an advisor, this becomes the baseline for discussion between you and your advisor.
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Smrutirekha Bhoi