Why your risk profile is important

Time and again we have always said that while there are general guidelines for investment, every individual should invest in an instrument only after carefully analyzing their needs, their return expectations, and their risk-taking capacity. Risk taking ability should be a special concern while investing. If taking risk into consideration wasn't important, everyone would be likely investing in either one extreme end, equity /risky assets or debt, of the asset allocation bar.

Understanding Risk Profile:

The risk profile of a person can be understood as a factor of his/her risk capacity and risk tolerance levels. The risk capacity refers to the amount of risk that the individual can afford and the risk tolerance refers to the ability of an individual to cope on an emotional level with the volatility of the market. It is important to understand the difference between risk capacity and risk tolerance. There are people who might be willing to take more risk but they cannot afford it, such a situation is especially where risk profiling proves its importance. Risk profiling tries to maintain the delicate balance between these two aspects. There is an another risk measure, ie., the required risk which refers to the amount of risk an individual will have to incur in order to achieve the required return.

An individual's risk profile can generally be decided using two approaches, these approaches are:

i. the life cycle approach

ii. the risk assessment approach

The life cycle approach:

While using the investor life cycle approach, individuals would be classified into different groups /stages. Thus, investors can be classified as young investors, investors with young dependent families, Investors with high income and stabilized expenses, investors close to retirement and retired investors. The life stage is then generally taken as the reference point and applicable assess allocation and/or product exposure is recommended based on the needs of this reference stage /group. Here, individual risk profile is really not assessed but more focus is given to experience/learnings from the personal finance field.

Let's say you are a 30-year-old man with two kids of age 3 and 5 years, thus your expenses are high and your income is still growing. Ideally, you should invest in a product which has a modest level of risk, provides an option for both growth and income and has a low lock-in period as your investment horizon at this point is uncertain. Here, if you don't understand the risk profile, you might end up investing in a product which is not suitable for you and thus, the decision might not turn as fruitful as you may have hoped.

The risk assessment approach:

Under, the second approach, the investor is basically divided into risk profiles based on an objective assessment of his risk capacity and tolerance levels. This is typically achieved through a risk profile survey or questionnaire. The investor is likely classified into either one of the three (or five) risk profile of conservative, moderate and aggressive.

It is on the basis of this risk profile that your portfolio allocation is be decided. Compared to the life cycle approach, this is a more direct and meaningful risk profile approach for an investor as it considers an asset allocation which the investor will be more comfortable with. For example, if you have a conservative risk profile, you are someone who doesn't want to take a lot of risks and thus you should invest more in fixed income instruments which are less volatile and invest little in equity instruments, which are highly volatile.

Importance or risk profile:

It is very important to define your risk profile while investing because, only once you understand your risk profile, you will be able to take an informed decision about your investments which is also in line with your long term goals. The importance of risk profiling can be summed up in three points:

i. To decide suitable asset allocation

Any portfolio construction is incomplete without asset allocation. It is never wise to put all your eggs in one basket and thus asset allocation is most of the times necessary to ensure that both the risk and expected return is at a comfortable level. To understand, what kind of assets one can invest in, one has to know his or her risk profile. For example, you cannot invest in derivatives if your risk profile is conservative, or you are someone who has growing needs and unsteady income.

ii. To match required return expectations

Every investor has different return and income requirements. An investor who wishes a return of say 15% in the long term and does not need a regular income, for that individual, investing in equity for long term makes absolute sense. However, if the investor cannot emotionally handle volatility in returns, then equity is not right the product. For such cases, one will be better off investing in a balance /hybrid product. Similarly, one cannot just simply invest in debt because he has a low-risk capacity, this way the investor will not be satisfied with the sort of return that will be generated and may not meet his life goals.

Both the scenario of either taking over exposure to equity or debt is detrimental. Higher exposure to debt creates a situation where, over long term, you fall short of the wealth you could have potentially created. This could jeopardise your life goals like child education or retirement. On the other hand, over exposure to equity may result in short term volatility which will see your wealth reduced and this too may affect your upcoming plans. A right balance, right asset allocation as per risk profile can save the day for you.

iii. To have a stable, meaningful wealth creation journey

The risk profile of an investor will change over time and at various life stages. For example, you may be a conservative investor when you were just beginning out but now that you have had some investing experience, you may be willing to take more risk. Similarly, while beginning with the investment you might still be building your career and had a young family to take care of, but eventually, once you have high income and stable expenses, you may be willing and also be able to afford to take on more risk. Thus, risk profiling is not important only at the beginning of investment but also should be conducted over time.

Having a portfolio that takes into consideration your risk profile will surely give you more comfort and confidence in your portfolio. This is important as any unexpected performance, either through volatility in portfolio or less than expected performance /returns can play havoc to your confidence. This may force one to make irrational, short-term investment decisions which are not logical and in one's best interests. A good marriage of risk profile and portfolio is thus important for a stable, long lasting and meaningful journey towards financial well-being.