Busting the myth around risk profiling

By Nidhi Manchanda

Knowing your risk appetite is a crucial step before starting an investment journey. However, relying solely on him to make all investment decisions is also not advisable. There is a way to best use it and this article will walk you through the “How” of it all.

But, before breaking the biggest myth of “Investing only according to your appetite for risk”. Let’s start with the basics first.

How can you know exactly your risk appetite?

The most popular way to do this is to complete a risk profiling questionnaire. This questionnaire is designed to find out your ability to take risks and your risk tolerance.

Risk-bearing capacity will depend on factors such as age, income, number of dependents, etc. Risk tolerance, on the other hand, is primarily understood by asking questions such as, “How would you feel if your investments dropped by 20% or more?” or “Will you always stay invested?” Or will you withdraw to limit your losses? »

The answers to these types of questions would give an idea of ​​whether a person has a high risk tolerance or a low risk tolerance.

Understanding the different risk profiles

Well, if anyone has been investing for a while, they must have come across these risk profiling questionnaires that determine an investor’s ability to take risk and overall risk behavior. The outcome of these risk profiling questionnaires will generally inform the individual which of the five risk profiles below is theirs;

  1. very aggressive
  2. Aggressive
  3. Moderate
  4. Conservative
  5. very conservative

Usually, based on the risk profile, an asset allocation is offered to an investor. A very aggressive investor would be recommended to invest 100% of the money in high risk investments such as equity market, PMS, small and mid cap stocks or sector exposure.

But is it right to invest 100% in highly volatile assets even if he is a very aggressive investor? Do we also assume, for short-term goals, to invest in highly volatile assets?

Likewise, a very conservative investor would mainly be recommended to invest only in low-risk investments such as FDs, RDs, PPFs, mutual funds, etc.

But shouldn’t we encourage such an investor to have some equity exposure for long term goals and educate the investor that it is hard to beat inflation by continuing with low risk, low return investments ? Going against the result of a person’s risk profile from these questionnaires can help build wealth.

It is therefore difficult to follow the risk profiling questionnaire directly as a first step. Some of these challenges are;

Two major challenges with this approach

1. Investor bias – When answering a typical risk profiling questionnaire, do investors mean what they answer? Speaking from people’s experience of dealing with clients, most people say they are not willing to take very high risks even if they want higher returns. Additionally, investors who have told their financial planners that they are very aggressive end up withdrawing their money after watching the markets drop 10-15%. Are they very aggressive? This is also true in another way for conservative investors. Also, often the investor himself is unsure of his risk tolerance, especially new investors.

2. Avoid the investment horizon – In the event that an individual obtains a very aggressive risk profile as a result because he or she is young, has no dependents, etc. The suggested asset class would be primarily stocks. However, what if most of that particular individual’s goals are short term and high priority? It is not suggested to invest in high risk investment options like stock markets for a one year target. Although the investor is asked about the investment time horizon in the risk profiling questionnaires, he is limited to selecting a single option. The goals can range from 0 to 30 years and the quantum of the goals can also be very different.

Due to the above two challenges, one should not blindly follow the risk profile as the only step in deciding the asset allocation within the investment strategy.

So what are the solutions and the right approach?

While it’s important to know your risk appetite, simply investing based on your risk appetite isn’t a very wise choice. Follow the steps below.

Step 1 – List your goals

Make a list of all the financial goals you would like to achieve in the future. It can be the purchase of a vehicle, a house, going on vacation, higher education, the education of children or marriage, retirement, etc.

Step 2 – Create 3 groups of short term, medium term and long term goals

After listing the financial goals, next to each goal, write the time horizon to achieve each goal. Sort all goals into 3 categories – short term, medium term and long term goals.

Short term would be goals that go up to three years. Medium-term goals would be those that are between 3 and 5 years. Any goal that has a time horizon of 5+ years is placed in the long-term bucket.

Step 3 – For each goal basket, create a risk profile

An individual cannot have a single risk profile, but rather take different levels of risk according to different financial goals. The basket of short-term goals should include low-risk investments. It is suggested that medium-term objectives be achieved through medium-risk investments. Have long-term exposure to high-risk investments like the equity asset class.

Investor risk appetite will play a role here. Let’s say that in the long-term goal, a person with a conservative risk profile should invest in index or large-cap mutual funds, and a person with an aggressive risk profile is recommended to invest in stocks. fundamentally sound small cap stocks.

Based on this, create an asset allocation strategy, i.e. how much to invest in stocks, debt, gold, real estate and alternative assets.

Step 4 – Check your overall asset allocation

The last step would be to check if the individual is not overexposed to a particular asset class. If so, the person should make some changes in consultation with the financial planner.

All of this may sound complex and therefore it is highly recommended that you consult a financial expert for assisted financial planning services to take care of all of this and more. Simply checking risk profiles online and starting to invest may not be the best and wisest decision.

So use risk profiling the right way.

(The author is a certified financial planner and responsible for training, research and development at Fintoo. The opinions expressed above are those of the author and not necessarily of financialexpress.com)

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