If there is one thing that the equity market is associated with, it is ‘risk’. Per a strictly financial definition, risk refers to volatility in the market. However, several investors associate the term along the lines of losing out on their money or suffering fluctuations for which they were not prepared.
Since risk has such a hefty bearing on investment decisions of individuals, it is important to have an understanding of the risk profile to manage risks effectively.
What is a Risk Profile?
One can understand the risk profile as the quantification of risk tolerance of an individual.
Every individual has a different tolerance to market volatility or risk based on several factors like disposable income, age, et al.
Therefore, risk profiling helps both an investor and financial advisor to create a specific investment portfolio with an asset mix correlating to his risk profile.
Organisations also use the term ‘risk profile’ to define the potential threats to which it is exposed.
By identifying the risk profile, organisations can take corrective or pre-emptive measures to minimise, and sometimes, even avert impending losses. However, the term’s predominant use is found in the context of an individual’s risk tolerance.
Risk tolerance, on the other hand, refers to an investor’s willingness to take risks or the level of volatility in returns one is ready to deal with.
A risk profile example pertaining to risk-aversion would be of an individual who would rather maintain the value of their portfolio than aim for high or even moderate returns.
On the other hand, an individual who is prepared to withstand market volatilities with the aim to earn exponential returns is a classic instance of a risk-seeker profile.
Risk Profile Evaluation
Investors often vet their financial standing, i.e. balance between assets and liabilities, to evaluate the level of risk they can take.
Financial advisors also utilise the asset-liability balance of an investor as a towering factor of risk profile determination.
For instance, an individual who has several assets at his/her disposal in comparison with very few liabilities will likely be a risk-seeker.
An individual with sufficient retirement capital, emergency funds, and no loans will be in that category.
Since such investors’ financial standing would not suffer greatly due to short-term market volatilities, they can afford to look at the bigger picture of exponential returns at that cost.
However, an individual whose asset value is not all that substantial, but his/her liabilities count is significant will most likely be risk-averse.
This category of investors possess limited wiggle room in their budget for accommodating loss from short-term volatilities and will be definitely more inclined to look for a safe investment haven.
One should note in this context that a healthy share of assets and fewer liabilities does not always prompt an individual to undertake a risky investment approach. It strictly depends on an individual’s own psychology of risk in that case.
Apart from the asset-liability balance, a few other factors that have a bearing on a person’s risk profile are:
|Age||Since young-aged investors are more likely to be welcoming of risk than individuals nearing their retirement age.|
|Lifestyle||Unmarried investors in the early stages of their career can afford to take risks compared to a middle-aged person with dependents.|
|Financial goals||Another critical determinant of risk profile is the financial goal of an investor. For example, if an investor aims to accumulate substantial capital for retirement, then he/she would go for a predominantly equity-based portfolio.|
Types of Risk Profiles
Broadly, the risk profile merits three distinctive types. These three types further constitute various subtypes based on variation in the factors mentioned above.
The three broad types of risk profile are:
Conservative risk profile refers to a significantly low-risk aptitude. Investors with this risk profile will lean towards investment options that provide the safety of the corpus more than anything. The scale of returns is a secondary factor to conservative investors as long as it is not negative. Typically, a conservative risk profile accounts for a short period horizon.
Investment options most suited for conservative or low risk-takers are treasury bills, corporate bonds, sovereign bonds, debt-based mutual funds, etc.
Moderate risk-takers usually strive to strike a balance between returns and risk. These types of individuals will go for high returns scaled to an agreeable level of risk. Therefore, a moderate risk-taker’s portfolio will constitute a moderate share of equities with debt instruments for adequate risk dilution. Such risk-takers can also singularly invest in equity-based mutual funds.
This risk-profile exhibits the most willingness for withstanding market volatilities in the expectation of earning exponential returns. Usually, these investors are seasoned and well conversant in the ways of stock markets. Apart from that, such investors also have a long-term investment horizon; which is why they can stomach the short-term volatilities.
These investors predominantly go for equities and usually have a healthy asset-liability balance, and sometimes young individuals with sufficient disposable income also fit this investment risk profile.
How is Risk Profile Prepared?
Usually, financial advisors and robo-advisors create the risk profile of investors by means of questionnaires. These questionnaires aim to fit the subjective risk-appetite of an individual in numeric terms or any objective field.
Also, they can contain choice-based questions or otherwise or both to adequately measure an individual’s risk profile, as the respective financial advisor or institution sees fit.
Nevertheless, any individual’s risk profile should be a well-thought mixture of what they are aiming for, return-wise, and the amount they are willing to invest, plus the period for which they can maintain such investment.