We often hear the warning, “Mutual Fund Investments are subject to market risk’. In fact, all investments inherently carry some elements of risk. However, risk in itself is nothing to be feared about. Risk denotes uncertainty in the outcome. Fortunately, risk can be managed.
Two Sides of the risk coin
It is for this very reason, an investor must fully understand the concept of investment risk and individual risk profiling. In simple terms, investment risk is nothing but the uncertainty of how an investment would pan out. “Will I make money or will I lose money?”, is the question that often plagues investors.
Investment risk measures the probability of making a loss. Risk is ubiquitous; It is present while crossing the road, travelling by train and similarly in an investment. Just like we are advised to look before crossing the road it is important to assess investment risk, before making an investment some people like to skydive, while there might be others who fret over taking a flight.
Each individual has a different capacity and willingness to absorb risk, which can range from high to moderate to low. It is imperative that there is an alignment between an individual’s risk profile and the risk of the investment.
What is your risk profile?
Risk profiling is a process which helps an individual understand and measure his ability and willingness to absorb risk, thereby enabling him to make optimal investment decisions. Risk assessment and profiling is integral to the investment process. Some of the key factors that can influence an individual’s risk profile are discussed below.
These include -- 1) Ability to take risks, 2) Need to take risks, 3) Perception of risk, and 4) Willingness to take risks. While some of these factors are behavioural in nature and require psychometric tests, others can be arrived at using mathematical models.
Ability to take risks
An investors’ ability to take risks is basically his capacity to take risks at different points of time in his life. The ability to take a risk can be strongly impacted by an individual’s current income, assets and liabilities.
For example, a salaried employee with a stable job, a steady income and some assets like a house will have a higher ability to take risk compared to an individual who has an uncertain income flow and no assets.
Need to take risks
Every individual has certain savings or income which help him meet his current expenses and future liabilities. At the same time, we all have financial goals that we aspire to achieve.
The need to take a risk could depend on your goals and how your income and investments can help you achieve those goals.
Perception of risks
This is a behavioural factor that impacts an individuals’ ability to absorb risk. While ability and need can be quantified, perception of risk can vary not only between individuals but also for a single person at different points of time.
It basically hinges upon how an individual views risk and can be gauged with his reaction towards extreme market conditions.
Willingness to take risks
This is another behavioural factor that impacts an individuals’ ability to absorb risk. It is primarily the level of risk that he is willing to take i.e. he is comfortable taking. There can be a case where an individual might have high ability and need to take the risk. But he might intrinsically be risk-averse and not be willing to take more risk.
A financial advisor can help you assess the above factors and arrive at an accurate risk profile.
Once you know your risk profile then you can make more judicious investment decisions that can help you fulfil your goals and ensure that you are comfortable with your portfolio allocation.
(The writer is Senior Fund Manager - Equities at BNP Paribas)