“Know your enemy and yourself and you can win all the time.”~ Sun Tzu in Art of War
This quote from the Chinese military strategist Sun Tzu sums up the importance of risk profiling in financial planning.
All investments have a risk-return ratio. Usually, this ratio is always positive, meaning the higher the risk the higher the returns possible from the investment. However, it is not just the investment that will decide your returns from it.
If such was the case, the millions of investors investing in equity markets over the last three decades would now stand on the list of billionaires. The truth, however, is that despite the millions investing in equities consistently, only a few thousand have managed to reach the same height as the markets.
If you are wondering why you are at the right place and risk profile is the answer.
What is Risk Profiling in Investment?
Money is an important factor in life. However, the way you earn money is by way of employment or business activity which adds some economic value. This employment will continue as long as you need to or physically possible.
The goal in real life is to become financially independent before you hit the retirement milestone. This is possible through investments and investments have a risk-return profile. Generally, long-term high-risk investments are best if you want to beat inflation and taxes to build wealth.
Your risk profile plays an important role in helping you manage your risky investments for maximum growth. The risk profile at any given point will consist of:
Your willingness to take higher investment risk, e.g.
a) How qualified you are with high-risk investments?b) Do you understand their workings?c) Do you have qualified advisors to manage such investments for you?
Your capacity to hold on to the high-risk investment for a long time
a) What percentage of your portfolio should be parked in risky assets?b) Can you manage your cash demands in different life stages without such investments?c) What is your longest investment horizon?
Why is your Risk Profile Important?
The method which is used to identify your risk-taking willingness, as well as your risk-taking ability, is known as risk profiling. A proper risk profiling will help you:
1) Maintain adequate liquidity through all stages of life2) Maximise your returns from long-term and high-risk investments3) Achieve your financial goals more efficiently4) Grow wealthier with time5) Manage your accumulated wealth better
In the case of investment, the risk profile is how you know yourself. Investment is the outside force that works in a specified way. But the experience of an investment will vary with investors due to differences in risk profiles and decisions making.
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How does your Risk Profile Help in Investing?
As discussed above, there are different risk profiles. These are created based on several factors psychological and financial factors.
The risk profile is broadly classified into the following five categories:
|Moderately Conservative||Very Aggressive|
Here are the characteristics associated with each type.
Here is an idea of how you can model your portfolio based on the category you fall in.
A conservative individual likes to take minimal or no-risk at all. A conservative investor likes to ‘play it safe’.
Here, the main priority is the safety of returns rather than the scale of returns.
Plans like the Guaranteed Savings Plan from Canara HSBC Oriental Bank of Commerce Life Insurance are perfect for this investor profile. This plan provides you full safety of the returns on your investment.
Your principal is protected and you are liable to receive guaranteed benefits on maturity.
2. Moderately Conservative
This is an extension of the conservative investor. Here the investor is ready to assume a little bit more risk for a better return. The suitable term is medium to long.
Here, the investor is neither too aggressive nor too conservative. A proper balance is maintained between risk and return. They aspire for a relatively higher return which comes with manageable risk.
An aggressive investor is ready to take risks. If you are an aggressive investor then you have high risk-taking capabilities. An investment made here is of a long-term horizon.
5. Very Aggressive
Here the investor takes on a very high amount of risk to maximize his returns, safety takes a back seat, and the scale of returns is of utmost importance.
Try to assess which category do you as an investor fall in. After you know which profile you belong to you can allocate funds accordingly in your portfolio. Below we provide some templates associated with each class.
|TYPE OF RISK PROFILE||ALLOCATION|
|1. Conservative||High Risk: 0-5% Safe Investments: 95-100%|
|2. Moderately Conservative||High Risk: 5-20% Safe Investments: 80-95%|
|3. Moderate||High Risk: 20-30%Safe Investments: 70-75%|
|4. Aggressive||High Risk: 30-40%Safe Investments: 60-70%|
|5. Very Aggressive||High Risk: 40-50%Safe Investments: 50-60%*|
* You will still need a large portion of your investments in safe assets to preserve the wealth coming from the aggressive investments and to maintain liquidity.
In options such as Invest 4G, you can take the advantage of automatic portfolio rebalancing. This feature enables you to set a specific allocation in which your funds will be invested.
Also Read - Best Saving Schemes in India
Six Factors Affecting Risk Profile
The risk profile is built up of many factors. Some of the major factors that influence risk profile are as follows.
1. Age and Dependents
When you are young and are just starting your career, you are likely to have fewer responsibilities by your side. At this stage, you can take more risks and invest in high-risk-return avenues.
How do Responsibilities Affect your Risk Profile?
But as you age your responsibilities grow. You are likely to get married and start a family. Your priorities start to change. Planning for your child’s education, marriage, and other needs takes a front seat. Thus, when you have dependents, you would like an investment that is safe and protects your returns.
Thus, your age plays a vital role in shaping your risk profile.
2. Family Background
Joint family, family wealth, financial safety and stability can help you manage more risk. The higher the risk you can afford to take the better returns you can afford to generate.
Thus, having a strong family helps your aggressiveness in the investment world. However, if you are in a nuclear family setup with a single income source, you should focus on safer investments first.
Moral Support Matters
Not only money, but the moral support from the family also matters. Backing and support from your family also matter while deciding the investment option to invest your money in.
A profession is a work you do to earn a living. The profession you are in can affect your risk profile. Here is how
How much do you Earn?
You can only think to invest if your basic needs are comfortably met and you still have substantial funds. Your income plays a defining role in selecting an investment.
A higher income means a higher appetite for short-term volatilities of the market. Thus, helping you to hold on to the volatile investments for longer and enjoy better growth.
Which Industry do you Belong to?
Having a desk job puts you in a relatively safe sphere. If your job is secure enough, you can look to take up more risks. On the other hand, if you have a business or are employed in a start-up, job security is likely to be less.
In this case, you have to prioritise your financial safety and must avoid market volatility on a large portion of your wealth.
4. Knowledge of the Market
The more knowledge you have about the market, the better you will be able to assess the risk associated with various tax-saving investments.
For example, if you are thinking to invest in equity, then the more you research about the stocks you are going to add to your portfolio, the better you have the idea of the sustainability of the investment.
With time if you build your expertise, you can even go for high-risk instruments which have huge growth potential.
5. Contingency Plan Strength
Life is another name of uncertainties, and often unplanned and unforeseen events can derail your long-term plan. To avoid such mishaps you need a contingency plan. The better your contingency plan, the more stable financial life you and your family can have.
Here are the things you should expect in and from your contingency plan:
a) Health Insurance
Look after medical emergencies without hurting your long-term investments
b) Emergency Fund
Save 6 to 9 months expenses in safe and liquid assets to ensure liquidity during downturns and job loss
c) Life & Disability Insurance
Ensure financial continuity and safety for your dependents in the case of your untimely demise or disability
6. Financial Goals
Risk appetite also depends on the goal you want to achieve with the investment. If your goal requires huge money, such as child education or marriage, etc, then you will need higher returns from your corpus.
If your goal is to keep money protected till retirement then you can opt for safer investments as well. Additionally, five years may not be a long horizon to park everything in equity funds, but 10 years definitely is.
Thus, your financial goals also play a role in defining your asset allocation or portfolio risk along with the other factors.
Risk Profile Keeps Changing
Investing as per your risk profile will ensure long-term survival and prosperity for you and family. However, you should also know that your risk profile continuously evolves with time. So, often your investments should not consider your present risk appetite, but few years down into the future.