Risk profile is a measure of how much risk one should be taking while investing after considering all the factors such as one’s financial situation, needs and attitude towards losses. Risk means different things to different people. So, the risk levels vary.
What is risk?
The definition of risk is the degree of uncertainty or potential financial loss present in an investment decision. Now, when you look at ‘risk’, what do you feel? Do you see opportunity or fear? Do you fear those losses? Or do you believe that risk is an integral part of the investing process?
The answers to these questions will help you understand your risk tolerance. You need to focus on your behavioural tendencies. For instance, try and recollect how you reacted to the last loss you saw on your portfolio or whether you invested more when the markets crashed last time.
Your risk tolerance is a combination of your thoughts and your actions towards your investments.
What is risk tolerance?
Risk tolerance is said to be the degree of variability in investment returns that you are willing to withstand in your financial planning. In simple words, risk tolerance is the level of risk you are willing to take with your investments. Even though it may not be possible to gauge your risk tolerance accurately, you can have a good idea about it. While risk is about making gains, exploiting opportunities, it is also about tolerating the possibility of losses and the ability to withstand market volatility.
Behavioural scientists say that the fear of loss plays a bigger role in investing than the anticipation of gains. Since risk tolerance is about your comfort level with market uncertainty, potential losses will help you understand your risk profile.
Note that risk taking capacity is different from your risk tolerance.
How is it different?
Risk capacity is a mathematical measure of how much risk one can take before it affects their financial goals. Note that it is about your ability to take risks and not willingness. Risk capacity is based on your financial situation. Risk tolerance is attitudinal and may or may not change throughout your life.
However, your risk capacity will change depending on your finances, life and financial goals. Even the time horizon needed to achieve those goals will have an impact on your risk capacity. For instance, if your kids are set to go to college in a year or two, you may be less likely to take on high-risk investments. However, if you are single and have no dependents, you might be willing to put your money in riskier investments.
Changing life circumstances will also change your risk capacity. For instance, a job loss or an accident leading to disability can change your risk capacity. Even an inheritance that you receive will change your risk capacity. So, risk capacity is how much you can afford to take and risk tolerance is how much risk you are willing to take.
Your risk tolerance is decided by a combination of factors such as your life goals, your investment experience, time horizon for each goal, your financial situation, and your ‘fear factor’. A simple way to determine your risk profile is using the ‘age-based’ risk tolerance method. As you might know, a young investor having a long-term time horizon for his/her goals can take more risk. So, the ‘age-based’ risk tolerance method says that an older individual will have a short investment horizon and will have a low-risk tolerance.
How to understand your risk tolerance?
However, this method has several flaws. For instance, just because you are retired you needn’tshift all your money to conservative investments such as fixed deposits. Note that only equities can give you higher returns in the long run so they shouldn’t be dropped from your portfolio. With only debt investments, you might get lower returns. With today’s advanced medical science and higher life expectancy, the 60-year-old investor may have 20 or more years to live. So, use this as just the base for deciding your risk tolerance. Combine with factors such as your attitude towards losses, your finances and your need to take risk to assess your risk profile.
What are the limitations?
Your finances will limit your risk tolerance. An investor with a high net worth can take on more risk. The more your net worth, the more aggressive your risk tolerance can be. Those with limited capital are often drawn to riskier investments because of the lure of easy profits. They think they have higher risk tolerance and their risk capacity is low. They shouldn’t take decisions based on their risk tolerance alone. When too much risk is assumed with too little capital, they can be forced to sell. Always combine your risk tolerance and risk capacity to take investment decisions.
Finding your risk profile is a complex process of analysing your finances, needs and attitude. You can take the help of consultants at Wealthzi.com to make investments that are right for you.