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Risk refers to the degree of potential financial loss inherent in an investment decision, generally measured by downside in a portfolio or its volatility.
Introduction
Creating a personal financial plan is all about connecting where you are now with where you want to be in the future. It’s a balancing act that involves your current assets, what you’ll save and spend down the road, and the risks you’re willing to take to see your investments grow. But here’s the tricky part:
We all know that to make gains, we’ve got to take some risks. The real question is, how much risk is right for you?
Background
When you dive into the world of investing, you’ll often hear about three types of risk profiles: Conservative, Balanced, and Aggressive. The way we identify with one of these profiles isn’t a one-size-fits-all approach. It’s influenced by a mix of factors, including:
- Your age
- Your life experiences, not just in investing
- The current mood of the market (are we in a bullish or bearish phase?)
- Your personal and financial goals
- Your overall financial health etc.
Let’s say you’ve only considered a few factors and pegged yourself as an “Aggressive” investor. You go all-in on a portfolio full of high-risk investments. But what happens if the market takes a nosedive? Do you have enough accessible funds to keep your life goals on track for the next few years 😐 ?
Fun fact: Research has shown that bull markets make us an Aggressive investor while bear markets tend to change the same investor a Conservative investor 😊
Determining your risk profile isn’t just about gut feelings or the state of the market. It’s both a science and an art. A hasty or uninformed decision can have serious consequences.
In this blog, we’ll explore a structured approach to asses your Risk Profile that aligns with your goals, assets, savings, and willingness to assume risk and ultimately enhancing your investment success.
The Risk Profile
Knowing the right risk profiling lies in the heart of crafting investment plan that’s tailor-made to fit an investor’s unique financial situation and their comfort level with taking risks. It’s about ensuring that the recommendations you get are in sync with both your financial reality and your psychological readiness to take on the uncertainties of the investment world.
Think of creating a Risk Profile as mapping out a road trip 🚗🛣. Before you even turn the ignition, you calculate how long it’ll take to get to your destination and how fast you need to go. But it’s not just about time and speed. You also consider the ‘what ifs’—like the consequences of reaching late? How will that impact your journey?
As you hit the road, you’re bound by certain realities: the laws of the road that set speed limits 🛑, how much fuel you’ve got, and the flow of traffic 🚦. These factors can either speed up your journey or put the brakes on your progress.
Then there’s your personal driving style. Some folks love the rush of pushing the pedal, while others are content to cruise at a steady pace, enjoying the scenery. This preference is a big part of how you navigate the journey.
Just like driving, when it comes to investing, you need a blend of these elements—understanding your needs, acknowledging your capabilities, and knowing your comfort with risk. It’s this combination that shapes your investment journey. Focusing on just one aspect won’t give you the full picture. By considering all these factors together, you can develop a Risk Profile that truly reflects how you want to travel through your financial journey.
Risk Profile Factors
All the elements that impact your Risk Profile can be grouped according to three factors:
- Risk Need
- Risk Taking Ability
- Behavioural Loss Tolerance
In the following paragraphs I will explain the elements and how it impacts the Risk Profile.
Risk Need
To truly grasp the concept of Risk Need it’s essential to first pinpoint your financial targets 🎯 and calculate the return necessary to either grow your current assets or maintain them to support your future aspirations. You’ll need to consider how long you plan to work, along with how much you anticipate saving or spending each year. Once you have that figured out, you can move on to calculating the required Rate of Return 💹, which can be precisely determined using calculations that compare present and future values.
At this juncture in the risk-profiling journey, the objective is to measure the level of risk—or market ups and downs—you’re prepared to handle in order to reach your goals.
Breaking it down, the ‘Risk Need’ factor is a trifecta of elements:
- Rate of Return (%)
- Market risk environment
- Consequence of failure
Rate of Return
The Rate of Return is essentially your risk need’s other half. It represents the degree of risk you must be willing to embrace in your portfolio to achieve a certain financial milestone .
Let’s paint a picture: Suppose an investor aims to amass a fortune of INR 5 Crore in 20 years. If they’re saving INR 10,00,000 every year, they’ll need to earn roughly 8.80% annually to hit that target. In this scenario, the investor’s risk need aligns with a portfolio expected to return 8.80% per year, with anticipated volatility based on predictions about the financial markets, including how different investment classes interact and fluctuate.
Market Risk Environment
When you’re nailing down your risk need, it’s also vital to take a hard look at the prevailing interest rates and inflation, as these will influence your decision-making. Assessing both the present climate and future market prospects is a crucial step in crafting your investment strategy. Within this risk-profiling framework, it’s your job to determine if your expected Rate of Return is in the realm of possibility, given the market’s behaviour, and make adjustments to your goals or savings habits as needed.
Risk Consequence
Risk consequence is all about the ‘what-ifs.’ What if you don’t hit your financial target? This could range from minor setbacks to significant emotional and monetary repercussions. For instance, you might consider the risk of not having enough cash to buy a new car 🚘as tolerable. However, falling short on funds for a critical goal, like your child’s education, might be a deal-breaker. This aspect of risk consequence plays a pivotal role in deciding just how much risk is sensible to take on in your investment portfolio.
Risk Taking Ability
Understanding your ability to take on investment risk is a key piece of the financial planning puzzle 🧩. This involves looking at three main areas:
Goal Time Horizon
This is simply the length of time ⏳ you have to achieve your financial goals. It’s a critical factor that helps determine how much risk you need to take on. If your goals are far in the future, you’ve got more time to ride out the ups and downs of the market, giving you the potential to take on more risk compared to someone whose goals are right around the corner.
Need for Liquidity
Liquidity is just a fancy way of saying ‘access to cash.💷’ Depending on where you are in life, your need for ready cash can vary. If you’re still in the wealth-building phase, you might not need as much cash on hand, which can give you a bit more freedom to take risks with your investments. On the flip side, if you’re at a point where you’re using your investments to fund your day-to-day life, you’ll likely need more liquidity, which can limit the amount of risk you’re able to take.
Risk Capacity
This is all about how much financial loss you can handle without it affecting your standard of living. To figure this out, look at the big picture of your finances—how much you have invested, your overall net worth, and any other assets or income you have that could cover unexpected expenses. If a market drop could force you to cut back on your lifestyle, then your capacity for risk is probably on the lower end.
Important: The Risk-Taking Ability factors can change over time. Life throws curveballs, and as you move closer to your financial goals, your ability to take on risk typically decreases. That’s why it’s crucial to revisit these elements regularly, especially when your financial situation or goals change significantly. By keeping a pulse on your goal time horizon, liquidity needs, and risk capacity, you can make sure your investment strategy stays aligned with your ability to handle risk.
Behavioural Loss Tolerance
While we can measure the first two factors of a Risk Profile with clear-cut data, the third factor— behavioural loss tolerance—is a bit trickier. It’s deeply personal and varies from one individual to another. To get a grip on your behavioural loss tolerance, we often use detailed questionnaires, one-on-one discussions, and a review of your past investment decisions. Leaning too heavily on just one of these methods could lead to a lopsided view of how comfortable you really are with taking risks in your financial life.
In the risk-profiling process we’re discussing, behavioral loss tolerance breaks down into six key elements:
Risk Tolerance
This is all about how much uncertainty you can stomach when you’re making decisions about your money. Think of it as your personal threshold for financial risk—how much potential loss can you handle before you start to sweat 😥?
Risk Preference
This is where your personal feelings come into play. It’s how you mentally weigh the pros and cons of a financial decision. For example, you might generally prefer safer investments but still be open to taking some risks if the potential rewards are tempting enough.
Financial Knowledge
This one’s pretty straightforward—it’s what you know about money matters. It’s the financial facts, figures, and savvy you bring to the table when you’re faced with a decision 📚.
Investing Experience
This is the know-how you’ve built up over time from actually getting out there and investing. It’s the practical side of your financial knowledge—what you’ve learned from real-world experience.
Risk Perception
Here, we’re talking about how you view risk within the bigger picture of the economy. It’s your personal take on the risks you face, given the current financial climate 🔎.
Risk Composure
This is about how you react under pressure. If things get tense in the markets, will you stick to your guns, or will you react differently than you have in the past 😧?
Understanding these six elements of behavioural loss tolerance is crucial. They give us a window into how you’re likely to react to the ups and downs of investing, which helps us tailor your financial plan to fit not just your financial goals, but also your personal comfort level with risk.
Summary
Risk profiling stands as a cornerstone in personal finance planning. It offers a methodical way to grasp and navigate the risks involved in managing your money. By carefully evaluating your risk profile through the factors we’ve discussed, you’re empowered to make investment choices that are in harmony with your financial aspirations.
Remember, this journey is best undertaken with the support of licensed professionals 👩🏫👨💻. They bring expertise and guidance to help you chart a course that’s right for you.
Reference: CFA Institute
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