Understanding your risk appetite: Guide to Risk Profiling
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.
Here is an old fable:
One day, a child asked God - “If everything is already written in my destiny, then why should I wish?”
God replied - "Maybe on some pages, I have written, "As you wish."
Risk works in very similar ways. One may choose to continue to sweat away on the same things one doesn't want to do, and it might pay him well too. But sometimes, he needs to take the risk to do what he truly likes in order to achieve what he deserves. Every successful man tells a tale of how taking calculated risks helped him attain the pinnacle.
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.
What is a risk profile?
Simply put,
Risk Profile = Risk Tolerance + Risk Appetite
(Yes, risk tolerance and risk appetite are different!)
Risk tolerance refers to the amount of risk an investor can handle. It can vary with age, income, responsibilities, etc. Meanwhile, risk appetite (sometimes called risk capacity) is the amount of risk that an investor is willing to take in order to achieve his/her financial goals. This is more a psychological factor.
An example of a risk profile would be an investor who is nearing his or her retirement. Most likely, this person is ‘risk-averse’. Such an investor, who does not want to or cannot take risks with his or her investments, may rather want to maintain the value of his portfolio or settle for meagre growth than punt for high returns. On the other hand, an aggressive investor - say, someone in their 30s who has dispensable money from the sizable income he or she earns - is willing to take on higher levels of risks with the money and withstand market volatility in hopes of higher returns.
Why should I know my risk profile?
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 goes a long way in telling you which investment and approach will suit you.
Risk profiling 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.).
Taking from our previous example, the elder person nearing retirement may choose to invest in debt instruments or other safer asset classes while the young one may even choose to explore cryptocurrency as part of his or her aggressive investing style for the investment portfolio! If you are a newbie to investing, we highly recommend reaching out to a financial advisor to assess your risk profile before investing.
Why should my portfolio change according to the risk profile?
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.
How is the risk profile assessed?
It is 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.
Here, it is essential to note that it is purely an assumption that they will be open to risky investments. 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 screen 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.
Can I figure out my risk profile myself?
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 BMW out on the National Highway. You know that the machine can do 180-190km/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 300km/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.
There are two key takeaways here that gain prominence when it comes to investing:
- When what you can afford is more than what you want, listen to your wants, and
- When your wants are more than what you can afford, go with what you can afford.
Having said that, there are certain questions you can ask yourself to figure out where you stand on the risk-o-meter.
- For how long are you planning to invest?
- How do you foresee your income in the future?
- How many years do you have until retirement?
- Do you own the house you live in?
- Is your emergency fund full?
- Are you comfortable with stable investments, or do you seek potentially high returns?
Alternatively, there are free risk profiling calculators available online for the curious! Some of them also make recommendations of funds based on the results that you can explore.
How can advisors help with risk profiling?
Risk profile is as diverse as your fingerprint. Someone else’s risk quotient cannot be the benchmark to weigh yours.
Your investment advisor is best qualified to make a risk assessment for you. She will take all the relevant factors into account and explore the disconnect between your risk capacity and tolerance. She would then suggest suitable investments and strategies that match your risk levels.
Types of risk profiles and possible asset allocation strategies
Check out what kind of risk profile may suit your risk profile.
1. Very Low Risk
Investor Profile - Very low tolerance to risk; unable or unwilling to take on any risk.
Possible Asset Allocation - Equity: 0-10%; Debt and cash: 90-100%
2. Low Risk
Investor Profile - Low-risk capacity and tolerance; conservative in approach; only slightly higher risk profile than the ‘Very low risk’ investor.
Possible Asset Allocation - Equity: 40-60%; Debt and cash: 40-60%
3. Medium Risk
Investor Profile - Medium level of risk capacity and tolerance; willing to take risk but not too much; higher risk profile as compared to the ‘Low risk’ investor.
Possible Asset Allocation - Equity: 40-60%; Debt and cash: 40-60%
4. High Risk
Investor Profile - High level of risk capacity; has medium-high tolerance towards risk; higher risk profile than a ‘Medium risk’ investor.
Possible Asset Allocation - Equity: 70-90%; Debt and cash: 10-30%
5. Very High Risk
Investor Profile -Very high level of risk capacity; high tolerance towards risk; higher risk profile than a ‘High risk’ investor.
Possible Asset Allocation -Equity: 90-100%; Debt and cash: 0-10%
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.
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