Benjamin Graham, one of the greatest investors of yesteryears, famously said, “Successful investing is about managing risks, not avoiding it.”
Risk, to put it simply, is the possibility of something bad happening. In finance, risks are an inherent part of the investment. While the potential for returns is greater when you take greater risks, it is important to ensure those risks are calculated to protect your capital from suffering severe losses.
According to FINRA, approximately 6 in 10 households in America are investor households, i.e., they invest in securities. Despite the coronavirus-led pandemic wreaking havoc with lives, America saw a record number of participants at the markets in the recent year. These trends indicate that people recognize the power of investing and seek to jump onto the investment bandwagon, with hopes of good returns.
However, all investors, especially those newly entering the market, must keep in mind that their investments are always subject to market risk. While risks cannot be eliminated, a reduced risk factor will ensure you find the right investment opportunity to minimize the potential for loss. This can be done by assessing the risk profile of the investor and picking investments that match their risk profile.
What is a Risk Profile?
A risk profile is an estimate of an individual’s ability and disposition to take risks.
Simply put, Risk Profile = Risk Appetite + Risk Tolerance.
Risk Appetite is the amount of risk that an investor craves for or is willing to take on.
Meanwhile, Risk Tolerance is the amount of risk that an investor can afford to take.
For example, an investor nearing his retirement age might wish to quickly grow his corpus by investing in equity markets; that is his risk appetite. However, his risk tolerance may likely be limited by the fact that his salary income is soon going to go dry, leaving him no option but to preserve his capital as much as possible. He cannot afford to take on the level of risks associated with the stock market. While he might be able to invest a part of the portfolio, it might not be recommended for him to put his entire investment portfolio in equities.
Risk profile also takes into account the potential threats an individual investor is exposed to. Assessing the risk profile can help an investor identify the degree of risk he or she can sign up for. This will also help them strategize investments through suitable asset allocation within an investor’s portfolio to maximize their returns while also managing risks.
Every investor seeks high returns from their investments. If they’re in a position to tolerate market volatility, they may be willing to take more risks. Conversely, if an investor is not in a position to withstand market volatility, he or she may not be willing to put their money in risky investments that fluctuate with the market.
Types of Risk Profiles
An investor is likely to fit into one of the three risk profiles based on various factors. The three main risk profiles are as follows:
Investors falling under the conservative category are considered susceptible to minimal risks. These investors display a low-risk appetite or tolerance. Investment options preferred by investors with a conservative risk profile lean towards options that offer lesser returns but more likely promise the protection of their capital. Robust growth is not what they generally seek; rather, they look out for safety and guarantee of returns, albeit less, from their investments. The risk-taking ability of such investors is very low.
Investors with a conservative risk profile may seek investment options that do not expose them to price volatility in the underlying asset. They prefer options such as fixed-income investments, sovereign bonds, and debt-based mutual funds, where the scope of exposure of the portfolio to volatility is greatly reduced and returns are guaranteed at a lower rate of interest.
Investors with a moderate risk profile aim at earning a moderate-to-high return but are not necessarily averse to risk or willing to take on high risk. Moderate investors generally seek to get the maximum returns possible with minimal risk exposure for their investments. Investors with moderate risk appetite understand the risk-return balance and will only take a risk up to a certain threshold, no matter how promising the potential returns look.
Most investors with a moderate risk profile have a moderate time horizon for staying invested – ranging between 2 years and 5 years. Moderate investors generally choose options like equities, mutual funds, or debt assets.
Investors with an aggressive risk profile aim at getting the highest return on their investment. They are open to taking risks for the potential growth of their capital and generally have a long time horizon. Due to the long investment horizon, these investors can wait out the market volatility in the short term. Investors in this category may be able to tolerate high levels of risks, generally possess a high-risk appetite, and are seen as willing to invest in more volatile assets provided there is potential for higher returns.
Aggressive investors aim at developing a portfolio that has the potential to return multifold. Their investments may include equity and futures market investments, as well as alternative investments such as an investment in start-ups and cryptocurrency, in hopes of yielding high returns in the long run. The stability of interest returns is a minor concern for aggressive investors and the focus is majorly on the growth of their corpus.
How is risk profile assessed?
An individual investor’s risk profile depends on various factors. One commonly used indicator is reviewing the assets owned by the investor. An investor is assumed to be willing to take more risk if they own many assets and have minimal liabilities – where the income is more than their debts. This is because such investors are unlikely to be affected by the short-term vagaries of market movements.
Investors are likely to be risk-averse if they have more liabilities than the assets they own, making them less open to risky investments. An investor with no mortgages who owns assets like a home and a decent-sized retirement fund may be more likely to take risks than a person who has mortgages to pay on a house or a car and has just started a savings fund.
It is important to note here that an investor’s ability to take risk does not correspond with the said investor’s willingness to take a risk. An investor doesn’t need to take risks while investing just because they can afford it. Many investors like to play it safe and take negligible risks.
|Age||A young investor with fewer responsibilities may be willing to take more risk than a middle-aged investor who may be comfortable with taking some degree of risk for the sake of higher returns. A senior citizen may be risk-averse.|
|Personal profile||A married investor may need to consider the needs of his family before investing in risky asset classes. Expenses such as raising a child, saving up for college, or planning a wedding can be expensive. Capital protection takes precedence over growth in wealth.|
|Income||An investor who has a stable stream of monthly income may be willing to take a risk with a part of the money. People who earn a high income are also likely to be comfortable with a higher level of risk exposure in their portfolios.|
|Investment Horizon||The financial goals of the investor influence the time horizon of investment, which is also one of the deciding factors for risk profiling. The longer the horizon, the more the potential for the investor to afford to invest in riskier asset classes, giving them the capacity to ride over short-term market fluctuations.|
|Emergency Fund||Having a sufficient corpus in the emergency fund – suggested to be around 12-18 months of pay – will enable the investor to take more risk with money.|
Everyone wants to explore the stock market owing to the potentially high returns. However, an investor must know the market risks well to make big-ticket investments. Knowledge of the market is a very big factor in analyzing an investor’s risk profile. An aware and knowledgeable investor will know when and what degree of risk can be taken after carefully analyzing the market indicators.
Various other factors, such as previous experience in the market, amount of family wealth, insurance cover for oneself and one’s family, etc., also influence the risk profile of an investor. A risk profile depends a lot on the psychology of the investor and how he or she defines risk, too.
Why is Risk Profiling important?
Understanding your risk profile is very important because it helps investors craft an investment strategy that is best suited to their needs for wealth protection and appreciation. Investors can figure out what risk threshold they are comfortable with and how much they are willing to contribute in tandem with the expected returns.
Would you buy ice cream if you had a sore throat, or a dairy product if you are lactose intolerant? While you might be aware that ice cream or dairy is a risk to your health at that time, the potential returns – its feel-good factor and taste – still seem attractive. Similarly, risk profiling helps you assess the cost of the decisions you make for your investment portfolio, helping you find the right balance between attractive investment options and the risk you can afford to take. It tells an investor what options he or she may explore based on the economic condition of the investor.
If an investor is scared about losing money, they have a conservative risk profile and should ideally steer clear of investment opportunities in riskier assets such as equity. If an investor understands that they fall in the conservative category, they could scout for investment options accordingly. Similarly, if an investor is willing to take risks enough to know that they could potentially lose money as well, they have an aggressive risk profile. When an investor knows about the power of risk they are willing to take, they may invest in options that have the best capacity to yield returns based on their financial situation.
It is crucial that an investor knows and understands the kind of risk they are willing to take and invest in line with it. However, there is no hard-and-fast rule here. Investors may carry a fluid risk profile that can change with factors like income, age, demographics, etc.
Note that no two risk profiles are alike – everybody has their unique situations. That said, it is also imperative to understand that a risk profile is not a tag. If you are in your 30s and it has only been a few years since you started earning, you may have a moderate risk profile. However, as time progresses and you start earning big bucks, you may move on to becoming an investor with an aggressive risk profile. A risk profile is only an approximate indicator of the asset allocation an investor’s portfolio should have.
As the risk profile of an investor changes, their investment portfolio also must change. Therefore, risk profiling is not a one-time activity; rather, it is a process that can be adopted every time there is a change in circumstances for the investor or even on a regular annual basis, or as recommended by a financial advisor.
Investment Risk and Return
It is safe to say that both risk and return are proportionally linked to each other. High returns come at the cost of high risks, and low returns are associated with a low-risk factor for investments. High returns are not possible without taking at least a moderate level of risk. If an investor aspires to get high returns, they must be open to taking risks and not fear them.
While safer investment options like fixed deposits may carry marginal risks, the return they offer even in the long term is not enough to beat inflation. The investor essentially loses a little money here – theoretically speaking. This is primarily because rising inflation makes things expensive. Meanwhile, the time value of money acts to reduce one’s purchasing power over longer durations. Another risk with ‘safe investments’ is opportunity cost – the additional money one might have earned had he invested elsewhere for the same investment horizon.
Investors must also note that if an investment option demands low risk, it need not necessarily yield low results. There are always exceptions and an investor must choose an option that best suits them.
Benjamin Graham, the father of Value Investing and Fundamental Analysis, also said: “The essence of investment management is the management of risks, not the management of returns.”
Asset Allocation Based on Risk Profiling
One of the fundamental principles of investing is that you should never put all your eggs in the same basket. This stems from the fact that risk needs to be mitigated – an entire investment portfolio must not be exposed to risk. Portfolio diversification and asset allocation are primarily aimed at dividing the investment between asset classes with low correlation and distributing risk.
Risk profiling plays a predominant role in effective asset allocation. Traditionally, the ratio of exposure of a portfolio to equity (risky) and debt (less risk) for an average investor is calculated to be around 60:40. This is however not a rule written in stone, and can vary from person to person and the current interest rate environment:
- An investor in his early 30s earning a high income may be likely to take more risks due to fewer liabilities and responsibilities, and therefore, may be open to even an 80-95% allocation to equity and the remainder to debt – an aggressive risk profile that mandates an aggressive investment strategy.
- An entrepreneur, on the other hand, may be more comfortable with moderate asset allocation to equity and debt investments, irrespective of his age or income – a moderate investor profile with a moderate investment strategy.
- A single parent, or an investor with loans to pay and financial responsibilities ahead, may want to invest conservatively, prioritizing capital preservation over the potential for quick growth. Therefore, they may choose to invest a larger portion of their portfolio in debt instruments – a conservative investor who seeks a conservative investment strategy.
Asset allocation should ideally be dynamic – it must change with a change in circumstances for the investor. For many investors that are in retirement, they may not have a choice if they don’t want to run out of money in their 80’s or 90’s. Their time horizon may still be 20-30 years out if they are in their 60’s. A higher allocation to equities of 90% may be warranted.
Along with every such change, a reassessment of one’s risk profile is also recommended.
Investors must not treat risk as a threat but as an opportunity that allows investors to create wealth in the long run. Like Mark Zuckerberg once said, “The biggest risk is not taking any risk.”
Understanding your risk profile before you start investing or moving your finances around is important. It lets you know what is doable and what should preferably be avoided.
Understanding your risk profile is a great way to know what assets you could invest in and the percentage of allocation in those assets for maximum benefit. An investor’s risk profile should be a careful mix of what their investment goals are, what amount of capital they are willing to invest, and for the period in which they can hold their investment without liquidating it.
However, note that risk profiling is only a suggested technique for effective asset allocation and investment strategizing. It is not a compulsion. An ideal investment strategy should comprise what you are comfortable with and what you are willing to withstand for the sake of returns. Identifying a risk profile is not a necessary exercise, although it might allow investors to better understand themselves and how they want to invest.
The aforementioned identifiers and determinants can give you an estimate of how to measure your risk profile. Nevertheless, your financial advisor is best placed to undertake the activity for you. They can help assess your financial, familial as well as emotional state and use it to create a customized plan for your investments.