Importance of knowing our risk profile
We hear that life is all about taking risks, if we never take risks, we will never achieve our dreams. Similar is the case with investments but with two certain conditions – Our ability and our willingness. It all boils down to these two things. We face risks in every walk of life – there is a risk of an accident when we are travelling or the risk of losing a job on which our family depends. Therefore, risk is something that cannot be avoided. However, it can be managed in a way that we can reduce its magnitude and impact.
What do we mean by risk profiling?
Risk profiling implies gauging an individual's willingness and their ability to take risks. The main aim of this activity is to simplify the process of understanding individuals’ attitudes towards investing and their probable reactions to future events. For instance, in case the markets collapse - how one reacts, whether they hold their investments, invest more or sell all in panic. Everyone thinks and acts differently, especially when it comes to decision-making. While making decisions, one's reactions tend to be considerably influenced by their mindset, attitudes, current situation, past experiences etc.
Importance of understanding our risk profile
The hard truth is that we may never know how our reaction to a particular market situation will be until we actually experience it. Steep market falls have stripped many brave investors of their ability to hold on to their investments. Proper risk profiling ensures that our asset allocation is in line with our attitude, other psychological attributes and our current situation. This will enable us to take better decisions when it comes to our money as it helps to avoid triggering the panic button and selling-off our investments. It even stops us from investing out of greed. While investing, people usually consider the rate of return that an investment is likely to generate. Although it is one of the important factors, it is equally important to understand the risks associated with that particular investment.
Risk profiling often helps people to pass the sleep test. If our investment returns are keeping us up at night, then we are probably not invested in a way that is right for us, matching our tolerance level.
It is very crucial to measure our emotional tolerance level. This helps to understand how we feel about certain events that affect our investment portfolio. To understand this in a better way, we can ask ourselves few questions such as how a 15 to 20 per cent fall in our portfolio affects our mood, how a 5 to 10 per cent rise in our portfolio affects us, if there is a loss of job, how we would feel about the investments that we have made. Irrespective of how well our investment portfolio is meeting our financial needs, if it is very risky or volatile or if we cannot handle the volatility emotionally, it does not make sense to continue with it.