What is Risk Profiling and why is it important? – Time to know yours

What is Risk Profiling:

All of us need to understand that Risk Profile is one of the most important area to be considered while investing, but often missed. In this blog we will understand what is Risk profiling and importance of Risk Profiling in investing.

Most of us participate in some or the other sports or physical activity. It can be walking, swimming or cycling or any other sports. Some of us like to be a little more adventurous who get themselves into difficult sports or physical activity such as trekking, bungy jumping etc. However, for the few of us who are rare, the simple adventure is not the game. They want to enjoy something extremely adventurous. They participate in extreme treks like climbing Himalaya or Parachute Jumping from high altitudes or running an Ultra Marathon.

 

Every human being is different. His/her thought process is different from others. Similarly, physique is also different from others. And diet surely is different from others. This difference makes a person take risk which, as compared to others, is either low or high. High risk takers are mentally tough, have better physiques and upgrade themselves with better diets. They can naturally take higher risk than someone else who is comparatively psychologically weaker or does not have equally good physique. In short the factors that enable a person to take risk are a combination of various factors. 

 

When it comes to investing, the risk positioning of an investor can be based on various factors. These factors are –

Risk taking ability

Willingness to take risk

Need to take the risk

 

Lets understand this with few examples –

  1. A person who has good net-worth, good cash surplus and has no major liabilities, is considered to have HIGH Risk Taking Ability. This person may not NEED to Take Any Risk as most of his goals are funded. At the same time this person may not be WILLING to Take much Risk. In such a scenario his risk taking positioning is assessed based on all the three factors above and the same can be tilted towards lesser amount of investing risk.
  2. A person who is struggling with his finances with the fact that he does not have a good cash flow and he is debt ridden(Low Risk Ability). However his goals are approaching and he needs to fund the goals. For that, he may need to earn better returns on his investments (Need to take high risk). But at the same time he is not positioned to take much risk in his investments, as he can not afford to lose the capital. Here again all three factors are assessed to decide the risk positioning of this person.

This is how Risk Profiling is carried out:

This Risk positioning of an investor is assessed with the help of the process of Risk Profiling.

Risk profiling is done with the help of a Risk Profile Questionnaire. This questionnaire has many questions which are psycho-metrically designed to understand the inclination of the investor. Each of these questions has 5 optional answers. The investor is supposed to choose one answer. Total score is calculated based on all his answers. Finally his Risk Profile is arrived at.

 

When it comes to investing, every investor should know what kind of risk he/she is taking in his investment instrument or investment portfolio. 

All of us know that the process of investing has various risks involved. In any investment the returns depend on the risk involved in that investment. So it forms a simple equation –

 

Higher the investment risk -> Higher the expected returns

Lower the investment risk -> Lower the expected returns

 

At Bonvista, we define the Risk Profiles of our investors as below. For every investor we arrive at one of the following Risk Profile based on the Risk Profiling activity-

Defensive Risk Profile – An investor who is almost not positioned to take any risk while investing, even though it is at the cost of returns.

Conservative Risk Profile– An investor who is positioned to take very little risk, but is willing to earn little better returns than the inflation

Moderate Risk Profile– An investor who is positioned to take substantial risk to earn moderate returns

Growth Risk Profile– An investor who is positioned to take substantially high risk to earn good returns

Aggressive Risk Profile– An investor who is positioned to take very high risk to earn high returns though it is at the cost of his capital

 

Why Risk Profiling is important:

For every advisor, understanding the Risk Profile is the most important part of the process, as the investment portfolio design depends on investor’s Risk Profile 

 

Asset Allocation is a very important process which comes after Risk Profiling. This process is all about deciding where to invest the money.

 

Read: Asset Allocation….Why and How?

Read: Asset Allocation and Diversification: How are they different?

We follow following process to finalize investment portfolio of our investors:

Risk Profiling -> Goal Integration -> Asset Allocation -> Instrument Selection  ->  Diversification -> Implementation -> Periodic Review -> Results   

 

So, you can see, if you do not do the Risk Profiling, the whole process may go for a toss. It is like ‘not deciding the destination’ before starting the journey. A ‘No Risk Profile’ or ‘Wrong Risk Profile’ can cost money to you as an investor. You may miss the very objective of your investment.

Let me know in the comments below- 

How did you find this article?

Whether you have done proper Risk Profiling before making your investments?

 

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