There are mainly two factors you should be clear about before investing in mutual funds.
First is your risk profile and second is the holding period (amount of time you wish to stay invested for).
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Most of the investors face problem in figuring out the first factor. Especially, the new entrants, they have a very little idea of the risk involved in mutual funds. Most of them are overconfident at the time of investing and turn extremely nervous as the market becomes volatile.
Hence knowing your risk profile remains at the center stage of any investment.
Without knowing your risk profile, you may go for investment that is not suitable for you. Especially in the case of mutual fund investment, one scheme cannot be claimed as suitable for all. Suitability of a product largely depends upon the characteristics of the investor.
What is Risk Profile?
Risk profile means understanding your investment traits. Hence, knowing your risk profile will help you design the right asset allocation.
There are various theories on assessing your risk profile, however, everything boils down to two things:
What is Risk Capacity?
Risk capacity is basically a measure of your ability to take risk. It depends on the factors such as your regular income, wealth, age etc. Risk capacity has nothing to with your behavioral traits. It depends on the following factors:
The higher your regular income, the higher is your ability to deal with losses, hence higher is your ability to take a risk. For example, a person with a monthly income of Rs 2 lakh would not get affected much by a loss of Rs 20,000 in a certain month.
But on the other hand, a person with a monthly income of less than Rs 30,000 would be in a great trouble with the same amount of loss.
Our life is divided into various stages.
Each stage has certain goals and responsibilities associated with it. As the number of responsibilities increases, your risk taking ability decreases.
When you are young, you have fewer commitments and also long time for big goals in life – say your child’s education or your retirement.
That means, you can take risks, even get hurt a bit and yet be on your way to build wealth.
The more wealth you own, the lesser you could care about the loss. Hence higher wealth results in higher risk capacity.
Risk appetite is a measure of risk you are willing to take.
It considers the psychological traits and emotional responses that determine the investor’s willingness to take on financial risk.
Many times your risk appetite takes the driver seat in making an investment decision. The most important age bracket when these preferences are formed is between age 16 and 25.
These are precisely the years when one starts investing. Your experience in these years goes far in forming your risk appetite.
The combination of the above two factors is what better known as the risk profile of an investor. Any investment is suitable for you only if it falls within the preview of both your risk capacity and risk appetite.
Once you understand your risk profile you can go for appropriate asset allocation, which decides what portion of your investment should go to which asset class.
The spectrum of risk profile goes from very low risk to very high risk. Depending upon what part of risk spectrum you are lying, you can allocate your investment into 100% debt and cash to 100% equity, respectively.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.