Finance

Risk Profile and Asset Allocation

What is a Risk Profile? 

Risk Profile helps you identify the optimal level of risk that is just right for you as an investor. It is used to determine the asset classes (equity, debt, gold, etc.) and style of investment that you can be comfortable with (growth, value, etc.). 

Risk Profile can be understood by – 

Your risk capacity 

Risk capacity is your ability to take risks depending on the factors that can be quantified (your income, number of dependents, liabilities etc.) 

Your risk tolerance 

Risk tolerance is your willingness to take risks and indicates your emotional tolerance towards the ups and downs in the market and towards risk-taking in general. This is a psychological characteristic. This is also defined based on your understanding of various investment products in the market and their inherent risks. 

The risk you need to take to achieve your planned financial goals This is a financial characteristic. Required risk involves mathematical calculations along with a set of assumptions that will help you understand the level of risk you will need to take to achieve your financial goals. This can also act as a constraint for limiting risk, like in cases where investment time period is short. 

Your risk appetite is profiled keeping in mind multiple factors such as your finances, habits, behaviors, family orientation, attitude towards high volatility, age, etc. 

Factors that affect risk profile: 

● Lifestyle: An unmarried investor can afford to take risks over a married person with the responsibilities of sustaining a family. Basically an investor’s number of dependents affect his/her ability to take risks. 

● Finances: Every investor needs to assess his day to day income and expenses to identify the investible proportion (savings). Further he/she needs to assess his/her net worth by analysing the liabilities and assets. 

● Financial goals: Financial goals of an investor play an important role in defining the timeline of investment. For example, for a young investor planning for

retirement, the investment timeline is fairly long and hence, has the ability to stay invested for a longer period, which is important for equity investments. 

● Product Knowledge: Every investment product comes with its own risks. It is imperative to know investors’ understanding of them. Willingness is based upon this understanding. 

● In addition to the above, other factors like a person’s genetic predisposition and their own psychology as well as the people he/she interacts with can influence one’s views on risk-taking. 

Why is Risk Profiling necessary? 

A risk profile will give you a better perspective on how to invest your money wisely into high volatility investments like Equity Mutual Funds, Direct Equity and less volatile investments like Debt Mutual Funds, Bonds and Fixed Deposits. 

We cannot predict when the markets will go up and when they will go down, hence, risk profiling will help take strategic and calculated risks when it comes to investing. 

Why should you assess your Investment Product’s Risk Profile after you’ve created one? 

Before making investments you must assess your investment risk profile because it will help you understand your investment orientation and build a better investment plan. 

At times, the risk inherent in the investments will be high and you may not be satisfied with the returns generated or the risk inherent in the investments will be too low whereas you may wish to take higher risks to generate higher returns. 

Therefore, by assessing your investment risk profile, you will feel more confident to invest because there will be a sense of content and comfort attached to the level of balance between the risks you take and the returns you generate. 

Why do you need a Wealth Manager? 

It is always good to seek expert advice. A professional can help you evaluate your risk profile taking several relevant factors into account. They can then help you devise investment strategies that match your risk profile. They can also help handle conflicts between your risk capacity and tolerance. For instance, an investor may have a high risk capacity but low risk tolerance or even vice versa. This is helpful as your attitude towards risk and your ability to take financial risks may change.

How does Risk Profile help in determining Asset Allocation? 

Firstly, what is asset allocation? 

Asset Allocation involves segregating one’s portfolio into asset classes like equity and debt. It is designed based on the understanding that different asset classes carry different risk-return characteristics and a combination of these will bring diversification and optimise risk-adjusted returns. 

There are studies which suggest that almost 91% of an investors’ returns can be explained by asset allocation during the investment period. 

Having highlighted the importance of Asset Allocation, the next part is how risk profiling helps in determining the same. Risk Profiling is essentially an input in the exercise which helps in ascertaining the appropriate mix between various asset classes such that the investors’ overall expected risk-return is as per their risk capacity, tolerance as well as financial goals. 

Now that we have an idea about Risk profiling and Asset Allocation, let us look at three major classes of investors under this approach: 

Conservative 

A Conservative investor values protecting principal over seeking appreciation. This investor is comfortable accepting lower returns for a higher degree of liquidity and stability. Typically, a Conservative investor primarily seeks to minimize risk from loss of principal. 

Allocation for these investors will be higher in debt and lower in equity. Like a ratio of 70 Debt : 30 Equity or 80 Debt : 20 Equity. 

Moderate 

A Moderate investor values reducing risks and enhancing returns equally. This investor is willing to accept modest risks to seek higher long-term returns. A Moderate investor based on his/her risk profile may endure a short-term loss in principal and a lower degree of liquidity in exchange for long-term appreciation. 

Allocation for these investors will be balanced in debt and equity. Like a ratio of 60 Debt : 40 Equity or 40 Debt : 60 Equity. 

Aggressive

Aggressive investors are more drawn to higher levels of risk in exchange for higher levels of capital growth. Based on their risk profile, they are comfortable with volatility and fluctuations over the shorter to medium term as long as they can achieve their objective of substantially increasing their real capital value over the long term. 

Allocation for these investors will be higher in equity and lower in debt. Like a ratio of 20 Debt : 80 Equity or 30 Debt : 70 Equity. 

Hence, by looking into an investor’s risk profile, one can determine asset allocation that is appropriate for them. 

Is risk profile constant over the entire investment period of an investor? 

The short answer is No. Your risk profile will change along with your finances, lifestyle, family information and your preferences for stability vis-a-vis risk-taking. Therefore, you need to update your profile at regular intervals to make sure your investments suit your profile. 

Risk profiling is a fundamental exercise that every potential investor must carry out. It will help you in the long run, to keep your financial plan in sync with your needs and ensure financial stability.

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