Investments are subject to market risk…
You might have heard this super-fast disclaimer in all stock market related ads. That’s because no matter where you invest, risk exists. Hence, you must understand your risk appetite and take calculative risks while investing.
But the question arises… How do you define your risk appetite?
That’s what we are going to understand in this article. So, let’s begin.
In this article we cover:
What is Risk Profiling?
How often do you get lured by a product just by looking at attractive rate of returns? Probably most of the time. At this point, investors often fail to match their risk profile with the investments risk profile, lock in their money and end up regretting it.
This is where risk profiling comes into picture. It helps you find the optimum level of risk you can take. Based on this, you can decide your ideal investment option.
But to analyse your risk profile you must analyse two major things.
- Risk appetite
- Risk tolerance
What is Risk Appetite and Risk Tolerance?
Risk appetite is the capacity of an investor to take risk. Whereas, risk tolerance is an investor’s psychological willingness to take risk.
Let’s understand this through an example.
Suppose you buy a new Mercedes and decide to take it out for a drive. The car can go up to a speed of 190 km/hr. But the speed at which you can drive to reach the destination is your risk appetite. This could be anything from 60 km/hr to even 120 km/hr.
Your risk tolerance is the speed at which you decide to drive. This could be 40km/hr. It is the speed at which you can cover a good distance with minimum risk of an accident.
Each investor has a different risk tolerance. For example, Mr Ram has a high-risk appetite along with the willingness to take high-risk. This makes him an aggressive investor.
Similarly, Mr Shyam has a high-risk appetite with the willingness to take medium risk. This makes him a moderately risky investor.
Why Do You Need to Understand Your Risk Profile?
Would you go skydiving if you are afraid of heights?
Similarly, if you know your risk profile, you wouldn’t blindly invest your hard earn money into any random investment option.
For example, if you are a conservative investor, cryptocurrency would not be your first investment choice. You will feel safer with a bank FD or liquid mutual fund.
Hence, knowing your risk profile is a must. It helps you make wise investment decisions.
Here are a few reasons why risk profiling is must for investors:
- If you know your risk profile, you can choose the right investment option.
- When you invest as per your risk profile, you have the conviction to stay invested even if there is short term volatility.
- When you invest as per your risk profile, you are aware of the expected returns you will make. This keeps greed at bay and prevents you from taking unnecessary risks to make more money.
- As you find your comfort level of taking risk, you can make a portfolio with investment options which makes you feel more confident and hence you can curate a perfectly balanced portfolio.
But risk profile is not constant. It changes as you grow older. Accordingly, your investment portfolio also needs alterations.
How Does Your Portfolio Change According to Your Risk Appetite?
We all have been to adventure camps in schools and Industrial Visits (IVs) during our college days. Because when we were young, the idea of a thrilling adventurous journey with lots of activities used to excite us.
However, if I ask my parents out for such a thrilling trip, they would deny it. But they would happily agree for a lunch by a sea side restaurant.
Similarly, the investments that might appeal to you today might not appeal to you when you grow older. With changing responsibilities, your risk appetite, investment avenues and portfolio will also change.
Let’s take a look at rule of 100 for measuring risk tolerance. It says that 100 is your risk tolerance. As you grow older you subtract your current age from 100. The result is the maximum percentage amount of the investor’s portfolio should be exposed to equities which are high risk in nature.
So for a 30 year old investor, this rule suggests that maximum 70% of his portfolio should be invested in equities.
Take a look at the table below and notice the change in asset allocation with growing age.
The table above shows the maximum allocation of your portfolio towards a particular asset. But there are several more factors which determines your risk appetite.
What Are the Factors That Will Help You Measure Your Risk Profile?
As time passes, there is a gradual change in your risk appetite. Investors in their 20s and 30s can afford to take more risks. Hence, their preferred investment option is equity shares or equity mutual funds. Whereas, investors in their 50s may opt for safe investment options like fixed deposits or Debt mutual funds. So, age is crucial in measuring your risk profile.
Amount of disposable income
Disposable income is the amount left after taking care of your expenses. If your disposable income is high, then you can take more risk as you are not 100% dependent on income from your investments. Whereas, if your disposable income is low, you cannot afford losses.
Next, you must think about your investment horizon. Here you have to decide the duration for which you would be investing. If you have a long term horizon, then you can afford to expose your portfolio to high risk investment avenues.
Whereas, if you have a short term horizon like for a year, then investing in a low-medium risk investment option is ideal for you.
Other than this there are a few more questions you must ask yourself to figure out your risk appetite better.
- How much returns do you wish to earn in future?
- How many years do you have until retirement?
- Will you be okay with stable investments or do you wish to have potentially high returns?
After determining all of these factors you can classify yourself into three major categories.
1.High risk profile: These are the investors who prefer investing in high-risk investment options like shares, equity funds with an aim to earn high returns. They are also known as risk takers or aggressive investors.
2.Medium risk profile: These investors have a uniform and balanced approach towards risk. They invest in a mix of high risk investment option like mid cap or small cap funds and low-risk investment option like debt fund. This is a simple diversification strategy through which investors can balance the risk ratio and earn high returns.
3.Low risk profile: These are the investors who are sceptical about investing. They are also known as risk averse investors. So, their portfolio is generally a mix of Fixed Deposits, Debt mutual funds, Gold Funds, etc.
Risk Profiles and Asset Allocation
|High Risk||Medium Risk||Low Risk|
|Investor Profile||Investors who have the ability to take high risk to earn returns.
These investors have high-risk ability and tolerance.
|Investors who wish to earn returns but with moderate risk.
These investors may have high risk ability but do not have high tolerance to risk.
|Investors who are satisfied with low returns as long as the risk is minimum. These investors have low risk ability and low risk tolerance.|
|Risk-Reward ratio||High||Moderate||Low to Moderate|
|Possible Asset Allocation||Equities, small-cap stocks, mid-cap stocks and commodities.||Large-cap funds, balanced funds, index funds.||Investments in Government bonds, government schemes, bank fixed deposits, recurring deposits.|
Investors often invest their hard-earned money on mere recommendations of their friends or so-called market experts without matching their risk profile with the investments risk profile. Such careless investments can prove to be harmful to your financial health.
Remember, risk profile of each investor is different. So, the investment option that works for your friend might not work for you. So, next time you hear about a lucrative investment opportunity, ask yourself – Does this investment opportunity suit my risk profile?
If not, then this investment is not the best one for you.
But the problem is most investors don’t understand how to diversify a portfolio according to your risk appetite.
Here are the returns generated by RankMF baskets.
|Fund||1 year||3 years||5 years|
|Best Funds for 1-2 years for Conservative Investor||13.59%||9.57%||8.90%|
|Best Funds for 5 Years for Conservative Investor||32.26%||14.65%||13.19%|
|Best Funds for 3 years for Conservative Investor||26.13%||10.72%||9.67%|
|Best Aggressive Funds to Invest -10 years||51.02%||11.90%||12.00%|
The above returns are as of August 2021. To check the latest data of all mutual funds- Click Here.
So, analyse your risk profile and time horizon and start investing by opening a FREE RankMF account today!