A check on investorâ€™s investment risk profile shall be made by him before making any investments. He must compare his risk profile with the inherent risk in each investment option the investor is considering. Investor then should make his investments in only those investment options, whose inherent risk matches that of his risk profile.
Each of us has a unique risk profile where investments are concerned. At the same time, each investment option carries a specified amount of risk. For instance, equity investing involves a higher risk than investing in debt.
It is important for investor to assess and understand his investment risk profile and match it with the investment options available in order to make investments in those options, which suit investor the best. In practical terms, investor can select a mix of investment options forming his investment portfolio which has a risk level similar to investorâ€™s investment risk profile.
The question that will come to investorâ€™s mind is, ‘How do I assess my investment risk profile?’ To do so, there are questions that investor will need to ask him self, which fall into two broad categories – (a) investorâ€™s risk-taking capacity and (b) investorâ€™s risk tolerance.
Under this category, investor will need to ask himself, questions whose answers can be objectively quantified. Questions such as investorâ€™s age, the number of dependants, investorâ€™s income, whether investor owns a home, etc. will fall under this category. For instance, if investor is below 30 years of age, investorâ€™s risk-taking capacity will be higher than if investor is above 50. Similarly, if investor has 2 dependants, investorâ€™s risk-taking capacity will be lower than that of a person who has no dependants.
Under this category, investor will simply need to question him self on his affinity or liking towards risk. There are a number of people who would have a low risk-taking capacity due to their age or high number of dependants or low income, etc. but who like taking risks. At the same time, there are investing people who have age, income, independence, etc. to their advantage, and still would prefer stacking their money in a bank deposit.
Once an investor has got a hang of his risk-taking capacity and tolerance, investor need to make an overall judgment of the amount of investment risk he can take. It is preferable to give more importance to investorâ€™s risk-taking capacity and to downplay his risk tolerance. This is especially true in case of people who like taking risks but don’t have the capacity to do so. Let’s consider the risk-taking capacity and tolerance of SK a 42-year old married man with two children.
SKâ€™s wife is a homemaker. SK has been employed as a Manager in a private company for the last 3 years. He is not satisfied with his job and has been scouting for an opening. SK has a modest amount of wealth build up and almost negligible savings for his children’s education and marriage. SK and his family live with his parents. SK loves trading on the markets. Considering SKâ€™s obligations (3 dependants), job instability and low wealth build up, his risk-taking capacity is low. It would make sense for SK to make his trading activities negligible and invest in low-risk options such as debt funds, post office schemes, etc. SK also needs to buy insurance cover on his life.
This will be useful to financially protect his wife and children in case anything was to happen to him.
The analysis of investorâ€™s risk-taking capacity and tolerance will lead investor to his asset allocation. Asset allocation is simply a decision on how much of investorâ€™s money an investor should invest in each asset class (equity, debt, property, commodities, etc.). Once investor arrives at his asset allocation, he can then decide on specific investments under each asset class. Remember, investorâ€™s asset allocation will not remain the same throughout his life. It will change with his progressing age, obligations, changing income levels, etc.