Why you should pay close attention to your risk profile while investing?

7 MinsAug 12, 2020

Risk profiling is the evaluation of an individual's willingness and ability to take risk. Risk profile is very subjective and may vary based on your age, financial circumstances, investment objective, personal experiences, risk-return expectations and time horizon to achieve the goals. Hence, it is of utmost importance to know your risk profile before making any investment decision.

Volatility is the measure of risk (often calculated using standard deviations), and higher the volatility higher would be the risk. Volatility in simple terms is how rapidly or severely the price of an investment may change.

Each of us can bear a certain level or degree of risk -- called our ‘Risk Tolerance’. It varies from an individual to individual and may determined by one or many of the following factors combined:

Age – At a younger age, usually risk tolerance is high as the investment horizon to realise your goal tends to be higher which means that one can stay invested in for longer and ride out the interim volatility to generate better long term returns. But as the age progresses the investment horizon may reduce and so does the risk taking ability.

Income – If you have a regular, stable source of income and your prospects look bright and/or you have higher number of earning members you may be comfortable taking higher risk in an endeavour to earn higher returns. On the other hand, if earning a regular income has been a challenge (for various reasons), the risk-taking ability too usually reduces.

Expenses – Similarly, your expenses affect the ability to save. Higher the expense, the lower will be the savings. So, along with your income if your expenses are also high then your risk-taking ability may be constrained. Thus, it is prudent to curb any unnecessary expenses and endeavour to increase the investible surplus in the interest of your long-term financial wellbeing.

The contingency reserves – This refers to the rainy day fund to address any exigencies. Having a sufficient corpus for contingency (ideally around 12 to 18 months of regular monthly expenses, including EMIs), may allow you to take relatively more risk. But if it is inadequate, that would impact the level of risk you may want to take. 

Your financial responsibilities – Providing for your child’s future needs, i.e. education and wedding expenses, and/or financial needs of any other dependent family member, home loan, etc, also influences your risk-taking ability. The more responsibilities you have, lower is the risk-taking ability. Only when you have made enough provisions for these, you may afford to take high risk.

Insurance cover – A suitable life insurance cover is also essential to provide financial security to your dependents in case of any untoward event. Inadequate life cover would lower your risk tolerance. Likewise, optimal health insurance cover is necessary to avoid utilising your savings and investments, in case of a medical emergency and hospitalisation.

Time horizon for your goal – This refers to how close you are before the envisioned financial goals befall. If you are sufficiently away from your financial goal (say over 3 years), you may afford to take higher risk. But if the financial goal is closer (less than 2-3 years away) or is critical, the risk tolerance usually reduces.  Hence, the longer your investment horizon the greater your ability to take risk.

It is important to understand that while risk tolerance implies to your ability to take risk, an investor also needs to understand his willingness to take the risk which is known from his risk appetite. The following factors may help you to decide your risk appetite:

Past experience – One’s past experiences may influence their future investment decisions. Typically, if in the past, you have been successful or had a positive experience with any investment product, you may not mind investing in that product again or to take on a similar level of risk. On the other hand, unpleasant experiences with any investment would lead to you staying away from it.

Knowledge – Having the know-how, is intangible and an invaluable asset. It helps you become aware of the nitty-gritty of various aspects and accordingly take informed decisions. Your level of understanding of the financial markets and investment products determines the willingness to take the risk. Greater your knowledge about financial products, higher will be the appetite for risk and vice versa.

[Also Read: Investor Bias – know what it is and how to avoid it]

A combination of factors under Risk Tolerance and Risk Appetite may determine your ‘Risk Profile’ which may categorise you as an aggressive investor, moderate investor or a risk averse investor.

Do remember, your Risk Profile will not remain static. It is dynamic and will change over time -- with your age, financial circumstances, change in outlook towards money, change in investment objective, personal experiences, risk-return expectations, and time-to-achieve the envisioned goals.

What should be your investment strategy?

It is important to align your investment decisions with your risk profile and in turn, asset allocation which is best suited for you basis your risk profile and investment horizon. Asset allocation refers to distributing your investible surplus across asset classes, viz. equity, debt, gold, real estate or even holding cash for that matter.

An intelligently drawn asset allocation is the cornerstone of investing that helps mitigate the risk by the diversifying the portfolio optimally. Every asset class offers a unique risk-return expectation and not all asset classes move in the same direction -- up or down -- at the same time always.

Equity as an asset class carries the highest risk, but returns too may be potentially rewarding if you select worthy equity-oriented mutual funds and/or stocks. Likewise, real estate is also relatively risky, but if you invest thoughtfully, it may prove to be a rewarding experience.

Gold, too, has the potential to serve as an effective portfolio diversifier with a tactical allocation (up to 10% of the entire investment portfolio) since it often commands a store of value during economic uncertainty.

Debt, on the other hand, offers the lowest return expectation and thus, lower risk.

Table: Traits, suitably of each asset class and investment avenue available

(For illustrative purpose only)

Investment is an important decision to make and hence, it is advisable to invest wisely based on your goals and not based on what your friend or relatives advice. Investing is an individualistic exercise. Your age, financial circumstances, broader investment objectives, financial goals and time horizon to achieve those envisioned goals are different. Hence, do not follow a one-size-fits-all approach. Keep in mind the old axiom: one man’s meat is another man’s poison.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision

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