Have you invested in the stock market? Do you know your risk profile? If the answer to the first question is yes and the answer to the second question is no, then you are making the most common error in investing – investing without knowing your risk profile.
Before selecting an asset class for investment, investors usually worry about the risk – no one wants to lose their hard-earned money. Also, some investors are ready to take more risks – they are comfortable taking them – than other investors. This difference will depend on many factors. The process of quantifying the risk-bearing capacity of investors is called risk profile. In this article, we will discuss it in detail.
Understanding risk profile
Before you invest in the share market, you must know your risk profile. You can understand its importance only if you understand the term. A risk profile helps you understand how much risk you can take and how much risk you should take to achieve your financial goals.
The risk profile has three components to it:
- Risk capacity: It is the level of financial risk an investor can take comfortably based on their life situation. It will depend on their age and other factors like marital status, dependent count, etc. In general, your risk capacity reduces as you grow old – for obvious reasons.
- Risk tolerance: It is more on the psychological level. It is defined as investors’ ability to cope with the fluctuation when they invest in the share market. It includes your response and reaction to various market situations – a correction or a crash. For example, some investors panic when they see their portfolio 10% down, while some are not too concerned about the fall. The former is an example of an investor with less risk tolerance compared to the latter category.
- Attitude towards risk: It is about your understanding of the risk. It also includes how much impact the risk will have on your financial life.
On top of these three parameters, the risk profile also includes evaluating how much risk is actually required. For example, not everyone needs to invest to achieve a 15% CAGR. If you can achieve your financial goals with a 10% CAGR, there is no need to take additional risk.
How to find your risk profile?
You may think that finding a risk profile is a big task, and you need to be an expert. However, contrary to popular belief, you only need a few minutes to know the risk profile. Knowing your risk profile is the first step in the risk management process. When you invest in equity, you need to manage risk at various stages – unless you know your risk profile, you cannot do justice to the risk management process.
There are many risk profiling tools available online that you can use to know your risk profile. Risk profiling is done by using a set of a questionnaire. Your answers are evaluated by a complex algorithm to evaluate your risk profile.
Benefits of risk profiling for equity investors
Risk profiling helps you as below:
- It helps you take the right risk so that your mental state is not disturbed when you invest your money.
- You can select the right stocks in line with your risk profile and goal – you get a perfect balance of risk and reward.
- It helps you identify your reactions to the market situation and ensure that the situation does not come in your financial journey.
Types of risk profile
Below are different types of risk profiles:
- Very aggressive: You are ready to take high risks for higher returns. You are comfortable seeing high volatility in your portfolio. You may have high allocation in smallcap and midcap stocks.
- Aggressive: You are a risk-taker, and therefore you are ready to witness volatility in the short term and expect your portfolio to deliver high returns in the long run.
- Moderately aggressive: You are a relatively moderate risk-taker. You are ready to take risks but want to keep a check – you have limited exposure to smallcap and midcap stocks.
- Moderate: You are a moderate risk-taker. Your portfolio will be less volatile and expected to deliver returns with some degree of risk and volatility without compromising stability. When you invest in equity, you have a high allocation in large-cap stocks.
- Conservative: You are a conservative investor, so your portfolio will be less volatile and expected to deliver returns that are stable with low volatility and yet protect your capital investment. You may want a mix of equity and debt in your portfolio.
- Risk-averse: You are a risk-averse investor, so your portfolio will be low on volatility and expected to deliver stable returns that might be lower compared to other risk profiles. You may avoid high exposure to equity in this case.
Risk profiling is crucial for every investor. We request every investor evaluate their risk profile and then only invest in the equity market accordingly. Equity investing should not give you a headache – if that is the case with you – you are going wrong in your journey. To make investing simple for you – you can try using Jarvis for equity investment – an AI-based tool.