With the rise in financial literacy offered by financial institutions and social media, the focus on personal finance is more than ever. It is safe to say that multiple media channels educate the public on managing finances and growing wealth. However, they all often leave out one aspect: risk profile.
Most literature highlights how to invest and which financial instruments will help them reach their goals while adding a disclaimer asking the investor to align their investments to their risk profile, rarely explaining what that means.
Retail investors who do not have a solid background in finance may overlook this aspect since the significance of understanding their risk profile is never highlighted enough. However, it is essential to remember that your risk profile plays a huge role in safeguarding you while investing.
Risk capacity, risk tolerance and risk profile are terms that need clarification before moving forward. Risk capacity is how much an investor needs to achieve a financial goal. It depends on the investor’s investment horizon, liquidity needs, income, wealth, tax rates, and other factors.
Risk tolerance is how much risk an investor is willing to take. Risk tolerance is dependent on the goals, income, age, life experience of the investor and the influence of surroundings. A risk profile is the combination of risk capacity and risk aversion. It determines how to allocate assets for a portfolio.
Risk profiling is essential and is somewhat an exhaustive process as there are a lot of variables to consider while analyzing the investor’s risk profile. The risk profile is important because the investor’s risk capacity and aversion should accommodate the investment’s risk.
A quick search on the internet will display numerous risk profile questionnaires to assess the type of investor the test taker is. The standard practice is defining your financial goals, filling the questionnaire, and getting the scores that help determine asset allocation.
These questions typically ask basic questions like the age range, emergency fund, income allocation, psychological willingness for taking higher risks, expected returns and other product specific questions. However, these questionnaires have their set of criticisms. The criticism often lies in framing the questions because they cannot gauge the investor’s risk aversion correctly, resulting in a limited profile evaluation.
According to several studies, some factors prove more reliable than the ones mentioned earlier. One of them is the investment history. By keeping track of past investments, we can understand the investor’s risk-taking level. However, suppose it is a potential investor. In that case, friends, family and other external influencers indicate the kind of risk attitude the investor may have.
While the questionnaires on the internet are not foolproof, you can still consider certain parameters to have a fair idea of your risk appetite. Parameters include thoroughly understanding your financial goals, the investment horizon, your age to assess how much risk you can take, your perceptions towards risk. Perceptions are framed through your interest, the time you live in, and your experiences in life so far.
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