The Importance Of Understanding Your Risk Profile
Risk profile reflects your behaviour in various scenarios and helps device a financial plan or investment portfolio that would help you to sleep well at night.
It is said that life is all about taking risks—if you never take risks, you will never achieve your dreams. We face risk in every walk of life, may it be the risk of an accident when we are travelling or the risk of losing job on which our family depends. When it comes to investments, it is no different story, but with some strings attached. It is more based not only on your willingness, but also on your ability to take risk—everything filters down to these two things, commonly known as risk profile of an investor.
So what does your risk profile mean? Risk profile means gauging individual's willingness and ability to take risks. The main objective of risk profiling is simplifying the process of understanding attitudes towards investing and try to understand probable reactions to future events. For instance, when markets collapse, how do you react—whether you hold your position, buy more, or sell everything in panic. Everyone thinks and acts differently. Specifically, when it comes to making decisions, one's reactions tend to be significantly influenced by the attitudes, mindset, past experiences and current situation, etc.
Risk profile in itself constitutes two distinct elements. The first is your risk appetite, which is concerned with your mindset, psychological attributes and how they might affect your future investing behaviour. For example, your probable reaction to an event such as winning Rs one crore in a lottery. What would you do in such a situation? This helps in determining your risk appetite. The second element is your risk tolerance, which depends upon your current life situation, say, your age, number of dependents, monthly income and size of emergency fund, etc. These are some of the key determinants of your risk tolerance level.
Now the question is: why is it important to understand your risk profile? The hard truth is that you may never know how your reaction to a particular market situation will be, unless you actually experience it. A market crash has stripped many brave investors of their ability to hold on to their investments. Proper risk profiling ensures that your asset allocation is in line with your attitude and other psychological attributes and your current situation. This will allow you to take better decisions when it comes to your money by neither panicking and selling off investments nor investing out of greed. It is the rate of return that an investment is expected to generate which is generally the first thing that is taken into consideration at the time of investment. Though it is definitely a very important factor, it is equally important to understand the risks associated with that particular investment. The risk profiling often helps people to pass the sleep test. If your investment returns are keeping you up at night, then you are probably not invested in a way that is right for you and which matches your tolerance level
If we go deeper to understand your risk, there are various things that we should take into consideration. As we know, every decision of yours is influenced by your emotions in some or the other way. So, it becomes really important to measure your emotional tolerance level. This will help you to understand how you feel about certain events that occur or happen with your investment portfolio. How a 15 per cent to 20 per cent downturn in your portfolio affects your mood? How does a 5 per cent to 10 per cent rise in your portfolio affect you? If there is a loss of job, how would you feel about the investments that you have made? No matter how risky or volatile your investment portfolio is, if you cannot handle the volatility emotionally, even if your investments were to meet your needs, it does not makes sense.
Another factor that you should consider is your financial ability to take risk. This will measure your overall financial situation and understand how much volatility can be added or reduced. If you are able to meet your cash flow needs, apart from your investment portfolio, then you might have high ability to take risk. However, if your investment portfolio requires periodic withdrawals, then your ability to take risk might be low .
Your financial personality highly influences your perception of risk and can end up mis-matching with the reality. You may think that markets are risky or not risky, but your perception may be quite different from the reality. For instance, if you are a risk taker and you may think that if market crashes or if something goes wrong politically or if the Reserve Bank acts in a certain way, you may make decisions that are not based on your emotional tolerance or financial capacity because you have wrong perception of risk. Because even though you understand risk and you are okay with it emotionally and also have financial ability to take the risk, then there are less chances of losing money in your portfolio and would also be able to make informed decisions.
Risk profiling is not a one-time activity. It is very important to re-evaluate your risk profile periodically and revise your investment portfolio or financial plan accordingly. This will help you to balance and understand as how your financial plan will react during times of downturn, upturn or in a mixed scenario.
So, at the end of the day, it is important to understand that your risk profile reflects your behaviour in various scenarios. Therefore, you need to device a financial plan or investment portfolio that goes with your risk profile. This would help you to sleep well at night with no anxiety of markets falling or rising