Understanding Your Risk Profile

May 8, 2011

Whether it is investing, driving, or just walking down the street, everyone exposes themselves to risk. Your personality and lifestyle play a vital role on how much risk you are comfortably able to take on.

We know investing is highly personal; everyone has different goals, timeframes and sensitivities to risk. We also know that every investment is subject to some level of risk. The first thing you need to do before you start investing is to understand your ability and willingness to take risks. In doing so, you will determine how best to allocate your savings among various asset classes. Not knowing what your tolerance to risk is or what you are investing in may cost you financially.

What is Risk?

Most people think of investment risk in one way: “How likely am I to lose money?” This statement describes only part of the picture, however. When considering how much risk you can take, you need to analyze your risk appetite against common factors such as your age, your attitude towards risk, the time-frame available for your strategy to work, your financial skills and (availability of time to utilize them), your net income, net worth, and your lifestyle.

Your Age

The younger you are, the more risks you can afford to take. You have time on your side to ride out the short-term fluctuations on your investments. Therefore, young investors can afford more aggressive investment strategies possibly involving equity funds.

If you are retired or nearing retirement, you should invest in low risk assets like fixed income and money market funds.

Your Attitude & Emotions Towards Risks

Different people react differently towards risks. Some are risk averse while some are risk takers. You should not take on any more risks than you are comfortable with. If you are the type of investor who is concerned about preserving the value of your investment, earning consistent modest returns over a long period of time, then you are a conservative investor. If you looking for higher returns with some protection for your investment, then you are a moderate investor. If you are looking for high growth in the value of your investments and are prepared to accept volatility in the short-term, then you are an aggressive investor.

In reality, investing is an emotionally engaging process because your hard-earned money is at stake. You should not let your emotions impact your investment decisions as that can raise the probability of making wrong decisions in haste.

Your Investment Horizon

You will need to take on more risks if your plan is to earn say Rs. 300,000 in the next 3 years compared to someone who plans to make Rs. 200,000 in 8 years. The higher the target return and shorter the time-frame, the more risks you will have to take to achieve your objectives.

Your Financial Skills

Generally investing in stocks is perceived to be riskier than investing in low risk assets such as fixed income and money markets. However, if you understand financial markets and economic trends, you may be able to reduce risks by selecting the right stocks. Your own financial skills and talent can play an important part in your investment strategy. An investment which is more risky to others might be less risky to you.
Managing risky investment such as equities is a time consuming activity that involves staying abreast of latest news, digging into corporate financial statements and dealing with brokers. If you are a full-time professional, then you will most likely not have adequate time at hand to perform these activities. In this case, it is better to invest through stock-based mutual funds where experienced and skilled professionals take on the responsibility of performing these activities on your behalf at a marginal cost.

Your Net Cashflow & Net Worth

The higher your net cash flows, the more risks you can afford to take. Net cashflow means excess cashflow after deducting all living expenses and financial obligations from your income. Also the higher your net worth, the more risks you can take.

Social Factors

Are you single or married? Do you have children or parents who depend on you for financial support? If yes, then you should be careful taking risks because any negative financial impact on your investments could affect these people besides you.

Conclusion

In summary, risk is a natural part of investing. You need to find your comfort level and build investment portfolios and expectations accordingly. Even though there are thousands of investment strategies available out there, the best strategy is the one you plan for yourself because only you know yourself best.