Risk profiling is a process that helps you identify the optimal level of risk that is just right for you as an investor. Your own risk appetite can be best understood after taking into account, the amount of risk you are able to take, your willingness to take risks and the risk you will need to take to achieve your financial goals. It is profiled keeping in mind multiple factors such as your habits, behaviours, family orientation, attitude towards risk, age etc. Risk appetite refers to the amount of risk you have the capacity to absorb, and this broadly helps determine the asset classes (equity, debt, gold, etc.) and style of investment that you are comfortable with (growth, value, etc.).
Your risk profile is broadly a factor of:
- Your risk capacity,
- Your risk tolerance and
- The risk you need to take to achieve your planned financial goals.
Let us understand these factors some more. Your risk capacity or in other words your ability to take risks depends on factors that can be quantified (your age, income, number of dependants, etc.).
Risk tolerance or your willingness to take risk indicates your emotional tolerance towards the ups and downs in the market and towards risk taking in general. This is essentially a psychological characteristic.
Required risk, is a mathematical calculation under a set of assumptions that helps you understand the level of risk you will need to take, to achieve your financial goals. Some experts may consider required risk to be a part of an individual’s risk capacity, which is essentially a financial characteristic.
Your asset allocation can be created based on your risk profile. Asset allocation implies deciding what proportion of your investments should be in various asset classes (equity, debt, etc.). Based on a comprehensive assessment of an investor’s risk capacity and risk tolerance, an investor can be broadly categorized under any one of these risk profiles and the resultant asset allocation:
| Risk profile | Investor profile | Possible asset allocation |
|---|---|---|
| Very low risk | Very low risk capacity and tolerance; unable to take on risk due to having too many financial obligations and/or modest income and wealth build up; has low tolerance towards risk. | Equity: 0-10% Debt and cash: 90-100% |
| Low risk | Low risk capacity and tolerance; cannot take on too much risk due to having financial obligations and/or modest income and wealth build up; has low tolerance towards risk; slightly higher risk profile as compared to the ‘Very low risk’ investor. | Equity: 10-30% Debt and cash: 70-90% |
| Medium risk | Medium level of risk capacity and tolerance; can take on risk but not too much due to financial obligations and/or modest income and wealth build up; has low-medium tolerance towards risk; higher risk profile as compared to the ‘Low risk’ investor. | Equity: 40-60% Debt and cash: 40-60% |
| High risk | High level of risk capacity and tolerance; can take on risk; financial obligations are taken care of; has good income and wealth build up; has medium-high tolerance towards risk; higher risk profile as compared to the ‘Medium risk’ investor. | Equity: 70-90% Debt and cash: 10-30% |
| Very high risk | Very high level of risk capacity and tolerance; can take on risk; financial obligations are taken care of; has good income and wealth build up; has high tolerance towards risk; higher risk profile as compared to the ‘High risk’ investor. | Equity: 90-100% Debt and cash: 0-10% |
So, when you are looking for investment options, you should match the risk they could expose you to, with your own risk appetite. For example, if you want to buy a 3 BHK house in 7 years, you should invest in instruments that are moderately risky such as mutual funds, gold, corporate bonds and so on.
There could also be instances where there is a mismatch in your Risk capacity and Risk tolerance, where you might have the capacity to take more risk but are unwilling to do so, or vice versa. So if you don’t assess your risk profile comprehensively before you invest actively, you may end up being uncomfortable with your investments.
For instance, you may have invested in a risk averse manner despite being able to, or being comfortable with taking on a higher level of risk. This would eventually make you feel unhappy as you will not be satisfied with the returns generated by your investments .
To access your risk profile there are a number of risk profiling tools and questionnaires that you can use to assess your investment risk profile, some of which are easily available online. Assessing your risk profile before making your investments is important since it helps you understand your investment orientation before you build your investment plan, thereby increasing the likelihood of your sticking to the plan over the long term. In other words, you are satisfied with the level of balance between risk and returns while you are investing. Without assessing your risk profile appropriately, you may end up being uncomfortable with your investments, because the risk inherent in the investments is too high and you are not satisfied with the returns generated by the investments or because the risk inherent in the investments is low while you may be comfortable with taking on higher risks to generate higher returns.