Estimate risk profile before starting to invest. It is essential to figure out the right investment strategy for an individual. A person who is risk averse shall not end up buying a high-risk investment. Similarly, a person with a high-risk profile will find debt-based plans unsatisfying.
Practically speaking, the majority of individuals fall between the extremes of low-risk and high-risk profiles. Such people fall in the range of moderate bandwidth. In fact, a majority of us have a moderate risk profile. Hence, an ideal asset allocation for us is to have a hybrid portfolio.
So we can say that there are three main categories of risk profiles: high, low, and moderate. The moderate is the category that encompasses most people from the investor community.
Risk and Investing
No matter where we’ll invest our money, there will be a risk of loss. It will not be wrong to say that risk and investment are the two sides of a coin. Why is it essential to realize it? Because more people are now investing in the stock market. Stocks are one of the riskiest forms of investment.
Before the COVID pandemic in 2020, about 40 lakhs Demat accounts were opened in a financial year. But since COVID, there has been a big jump in the number of new Demat account openings. In FY22, about one crore new Demat accounts were opened. This is an all-time record.
For Mr. Market, it is good news that so many people are participating. But it is also a reason to worry that all these new people are buying and selling stocks without proper training. These people are trading in stocks without realizing the risk-return trade-off.
There are people whose risk profile is not suitable for stock investing beyond a minimum percentage. But their investment portfolio is stock-heavy. What will happen to such people when the stock market nosedives? They will resort to panic selling leading to heavy losses.
What is the way out? Creating an investment portfolio mix that complements the risk profile of the investor. Hence, estimating one’s risk profile and formulating a suitable portfolio mix is an unavoidable requirement. Investing in risky investments beyond the allowed limits of one’s risk profile must be avoided.
Estimate The Risk Profile
Risk profiling is a process of quantification of the risk-taking ability of an individual. Profiling an individual is done with respect to an optimum investment risk suitable for the person.
Good investment managers would build their client’s portfolios tailor-made as per their risk profile. They would consider three things to judge their risk profile: risk requirement, mental preparedness, and current financial backup.
Three components of risk profile
Experts generally say that risk profile has only two main components, risk tolerance, and risk appetite. But I’ve added a third component called risk requirement. Even if a person is risk averse, if the financial goals demand some level of risk, it cannot be avoided. Similarly, a wealthy individual may invest only to protect the capital. Though he/she may endure a high level of investment, as there is no requirement for it, it can be avoided.
The other two components are the following:
- Risk Tolerance: It is basically the mental preparedness of the investor to psychologically absorb the downside movements. Here the downside movement is said with respect to the investment portfolio’s market value. If the person can psychologically bear only a 5-6% fall in the market value of his/her investment portfolio, it is an indicator of low-risk tolerance. High-risk tolerance individuals will not panic even if the market value falls by 30% or more.
- Risk Appetite: If the current financial situation of a person is strong, even a low risk-tolerance person can take higher risks. But a person in the early 20s will display a low-risk appetite if his/her financial health is unstable. Other than the financial health of an individual, there are other factors that contribute to the risk appetite of a person. We’ll discuss them later in this article.
People can be categorized into mainly five kinds of risk profiles as shown below. This estimation is done based on their risk tolerance and risk appetite levels.
Risk tolerance depicts the psychological setup of a person to deal with losses or the possibility of losses.
In risky investments, the market value of one’s investment portfolio can be very volatile in short term. Sometimes, the portfolio’s market value can fall up to 30% or more. In such moments of distress how a person behaves shows his/her risk tolerance. If the person remains unperturbed, it is a sign of high-risk tolerance. If the person goes into a panic and liquidates the holdings, it is a sign of low-risk tolerance.
What builds or erodes a person’s risk tolerance are the following:
- Past Experience: People who grew up during a low inflation regime will find index investing meeting their goals. People in growing economies might prefer a riskier alternative, direct stock investing. People who lost a fortune during the 2008 market crash might not have invested during the Covid crash and vice versa. People who saw their parents investing only in insurance plans might find stocks and equity funds too risky for investment.
- Inherited Genes: There are people who are naturally trained to handle investment risks better. Probably it is in their genes. They see market corrections and a crash as a more-buy opportunity. They do not panic when it happens. Instead, they feel happy that they have got the opportunity to invest again. Among such people will buy stocks and others would invest in pure equity funds. Some will find the hybrid fund as their safe bet. Perhaps our grandparents would have bought bank deposits even during a crash. The behavior of a person during bad times in the market tells a lot about his/her risk tolerance.
Even if the person is not a natural risk taker, but he/she has spare cash for investing, risk can be taken. I feel anyone can build their risk appetite. How do I do it for myself? By forcing myself to generate spare cash. It is done by paying myself first this amount, right at the start of the month. It happens before spending a dime anywhere else.
Generally speaking, a person’s risk appetite is a product of the following conditions:
- Current Financial Health: A financially stable person will have a more risk appetite for investments than others. What gives a sense of financial stability to anyone? Following are the factors:
- Stable & Surplus income: A high-earning salaried person might have a higher risk appetite than freelancers. A person who lives frugally will have more surplus income, hence a higher risk appetite. People who spend their money more freely might come up with less spare cash, hence will display a lower risk appetite.
- Size of Emergency fund: An emergency fund has several components in it. Two main are cash savings and insurance cover. The bigger will be the size of the emergency fund, the safer a person will feel about his financial condition. Such people tend to handle risky investments better.
- Current Investment Portfolio: The size and performance of the current investment portfolio also build the person’s risk-taking capability. It not only adds in terms of investment experience but also provides a sense of financial stability. A stable person tends to take more risks in investing.
- Investment time horizon: When the investment time horizon is longer, short-term market movements look less worrisome. A person investing money with a financial goal that is only 3 years hence will take only moderate risks. A person investing with a 20-25 years time horizon will handle risky investments with ease.
I would also like to mention the factor of investment knowledge in dealing with the risks of investments. People who are more informed about the process of investing tend to handle investment risks better. It is especially true for stock investing. People who are more aware of the stock basics tend to handle its investment risks better.
Risk Profile & Investment Strategy
When we estimate the risk profile, it is only half the job done. This knowledge must be put to use. How? By deriving a suitable investment strategy matching the estimated risk profile. To make better use of the derived risk profiles, we can convert the five categories into corresponding suitable return numbers. For myself, I’ve used the following return percentage numbers as symbolic of the five risk profiles.
For example, a person with a moderate risk profile shall have an asset portfolio suitable for generating a return between 8.5% and 11% per annum.
Taking a clue from the asset allocation shown above, we’ll now see which assets and what proportions of them can be used to generate the matching returns. Though I’ll agree that what is shown below is an oversimplification of the actuals. But it surely gives a fair idea of the concept of asset allocation and the creation of a risk-profile friendly portfolio.
These numbers are for DIY investors. It also assumed that the investor has a basic understanding of the asset type. In the case of novice, the weight in equity, gold, and REITs must be reduced. For such people, an investment portfolio will be debt-heavy. As a consequence, the average return of the portfolio will also fall.
If one can estimate the risk profile before investing, it will give direction to one’s investment process. No matter if one is a starter or a pro, the risk profile must be tested at least every 5 years. Why? Because people’s priorities change with age, as a result, their risk profile will also change.
Just by following the process of risk profile estimation, especially beginners will get a nice introduction to the investment cycle. Self-awareness about one’s risk-taking ability, return expectation, and asset allocation will be visible at a glance.
As a beginner, I used to follow a simple test to judge my investment risk-taking ability. I used to do this test every time before buying stocks. Suppose, I had Rs.5,000 as spare cash for investment. Before buying, I used to ask myself, what portion of the Rs.5,000, even if gets lost will not overly bother me? In those days, most of the time my answer used to be Rs.500. So I used to buy stocks worth Rs.500, and the balance was invested in mutual funds, etc.
Have a happy investing.