Impact of Your Risk Profile on Investments
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A lot of factors mark their active presence in decision making while investing. For example, the return profile of the target investment, past trends, dividend pay-out, market rapport, etc, all play an important role in investing. While most of these factors are related to investment instruments, the one major factor that depends on the investor’s attitude and appetite is investor risk profile. Risk profile majorly affects all your financial planning and investment decisions. Hence, it is important to have a clear understanding of the term risk profiling and its impact on investment returns.
Risk profiling is a combination of two factors: the willingness and ability to take investment-related risks. It answers the question of how much a person is willing to risk their money in an investment that they are able to cover up in case of a loss. The loss can occur due to various reasons, such as bearish markets, improper management, industry fiascos, etc. As a general rule of thumb, high return investments carry higher risk. That is why most financial planners advise not to base your investment decisions only on the returns but to look at a broader perspective relating to the target investment.
Risk Profiling and Risk Assessment
Now that you are aware of the fact that your risk profile plays a crucial role in deciding where to invest your money, the next step is to know how to gauge an investment based on risk. Risk assessment is the process that helps you identify the things you need to factor in to reach a conclusion that indicates which way to go.
In order to assess your risk profile, you need to answer a few questions like:
- What is your investment goal?
- What is your investment horizon?
- What is your total family income?
- How much money do you have at disposal for investing?
- Do you have any dependents?
- How old are you?
These are some important questions that need to be answered in order to make a better and informed investment decision and know where you stand in terms of risk.
Based on the answers to the above questions, your risk profile can be determined. Investors fall under these 3 primary categories:
1. Conservative Investors
Investors who have a low-risk profile are called conservative investors. These investors prefer sticking to investment instruments that are more stable and do not focus on capital appreciation as their main goal. Capital preservation along with affordable risk and related growth is the main agenda of such investors. Debt mutual funds, bank FDs, and other secured, fixed-income securities are the most preferred investment type for such investors.
2. Aggressive Investors
Aggressive investors are those who possess a high-risk profile and are willing to put a lot at stake when it comes to investing. These investors prefer investments that generate high returns and are highly volatile. Capital appreciation is the main goal of such investors and they do not shy away from maintaining an equity-dominant portfolio. Capital growth is the highest in this case but is accompanied by high risk as well. You need to be extra vigilant and proactive with your investments in order to avoid any damages and be unfazed by losses or shocks. Investing in equity-related instruments is the first choice of aggressive investors.
3. Balanced Investors
A majority of investors fall under the category of balanced investors also known as medium risk investors. These investors invest in a combination of high risk and low risk instruments and exercise both capital appreciation and capital preservation. The ratio can be adjusted as per the investor’s personal choice making the portfolio either equity-major or debt-major. Balanced investors possess an investment portfolio that contains both debt instruments and equity instruments with some fixed income securities as well.
Once, you have figured out the category you fall into, the next step is to understand the impact and effect of your risk profile on your investments.
Some of the most affected investment decisions are:
1. Asset Selection and Asset Allocation
The first thing to talk about while considering your risk profile is the asset selection. Every investor wants to earn the maximum potential of their investments but the difference lies in the level of risk they are willing to take up. Fund selection is the process of selecting the asset type you are investing in. As discussed above, a conservative investor would prefer a debt related instrument while an aggressive investor would prefer investing in equities. Asset allocation is also a related term that focuses on investing in different types of asset classes such as bonds, stocks, mutual funds, etc. Depending on your risk profile, your asset allocation should be carried out in a way that the investments are neither too risky nor too protected for your preference.
2. Return Expectations
Risks and returns are inter-related concepts when it comes to investments. A simple thumb rule indicates that risk and return are directly proportional i.e. higher the risk, higher the returns. Depending upon your risk profile, the asset allocation is a deciding factor in your investment return expectation.
Of course, aggressive investors would expect high returns as they are willing to put more at stake. Conversely, conservative investors would expect low returns as they are more focused on preserving their precious capital and are satisfied with moderate returns.
Portfolio diversification is a crucial concept that plays a vital role in the success of your investment career. Carefully observing the market trends and understanding the government and business decisions can have a direct impact on your investments and can be instrumental in ensuring a successful investing journey. Diversification is the process of investing across different sectors and industries in order to spread the risk and benefit from the progress of varied industries.
Depending on their risk profile, investors diversify across industries gauging them on their volatility. For instance, the FMCG (Fast-moving consumer goods) industry is one such type that is bound to flourish at all times as it offers products that have become a necessity to sustain a healthy life. Conservative and balanced investors would prefer investing in such companies.
4. Liquidity Requirements
Liquidity requirements are a major concern with investors of all types. Depending upon your risk profile, you can consider asset allocation in investment instruments that may or may not require a major lock-in of your money.
For example, fixed income securities generally come with a lock-in period of over 3 years but with assured returns and negligible risk. If you are willing to block your money over such a time period then you can consider investing in these securities. However, this may not be a preferable choice for investors looking for more liquidity.
To sum it up
Risk profile is an important aspect of investing that plays a major role in asset allocation and selection. Understanding one’s risk appetite is the foundation of investing and can determine a person’s chances of profits or losses to a great extent. Realizing the consequences of each investment is important and investors should in no way undermine the risk involved in their portfolio.
Are you concerned about the risk in your portfolio? It is always good to consult financial advisors and make an informed decision when it comes to investing your hard-earned money.