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Investment planning is a comprehensive exercise that takes many aspects into account. Most financial guides will tell you that to create your investment plan, you need to list out your goals, prepare a budget, and above all, understand your risk profile.
But what is this ‘risk profile’ all about? At first glance, it may appear to simply be the amount of investment risk you can take on. But in truth, your risk profile is so much more than that. In fact, there are three key aspects that make up the risk profile of every investor -
Before you invest, you need to take into account all of these three dimensions. But what are they exactly? And how do you factor them in? Let’s find out.
The risk appetite
Your risk appetite is the maximum amount of loss that you are willing to take on when you make an investment. Simply put, it indicates your readiness to take on investment risks. Based on your risk appetite, you can be any one of three main types of investors.
Type of investor
Details
Aggressive investors
These investors are comfortable taking on higher amounts of risk than other investor classes.
Moderate investors
Investors in this category are okay with taking on some amount of risk, although not as much as aggressive investors.
Conservative investors
Conservative investors prefer safer investment options that focus on capital preservation.
The risk tolerance
Your risk tolerance is the amount of risk that you can afford to take. Or, in other words, it is the level of risk that you are capable of bearing when you make an investment. This aspect is not based on your personal preference alone.
In fact, there are many factors that influence how much risk you are capable of taking on. Some of the most common influencing factors are outlined below.
Your age
Generally, the younger you are, the more risk you may be capable of tolerating. This is because you have more working years ahead of you, and you have time on your side. As you age and your retirement approaches, you may not be as capable of investing in risky ventures.
The investment horizon
Some financial goals may need to be achieved in the next 3 or 5 years, while others may have 20 years in which you can achieve them. Typically, the longer the time horizon available to achieve a goal, the more risk you may be able to tolerate. This is because in case you suffer any losses, there is more time to recover them.
Your portfolio size
The larger your portfolio size is, the more risk you may be able to take on. An investor whose portfolio value is Rs. 1 crore may be more risk tolerant than someone with a portfolio value of Rs. 10 lakhs.
Your income
This is one of the most important factors that determine how much risk you can tolerate. If you earn quite well and have a stable source of income, your risk tolerance may be higher when compared to someone who earns much less, or someone whose source of income is unstable.
The risk capacity
The risk capacity is the level of risk that you need to take in order to meet your financial goals as planned. Without taking on this minimum amount of risk, you run the risk of not achieving your financial goals as desired. Let us take up an example to understand how risk capacity works.
Say you have a specific financial goal to achieve. You wish to save up for an international vacation.
So, the long and short of it is that you need to build a corpus of Rs. 4 lakhs in around 36 months, by investing Rs. 5,000 each month. To do this, you need to invest in a product that gives you returns of at least 7% per annum.
This is your risk capacity. Clearly, you can meet this life goal by taking the safer investment option.
On the other hand, if a financial goal requires that you need an expected rate of return of, say 12% to 14%, you may have to choose a high-risk investment option.
Summing up: How do these three aspects influence your investment decisions?
The gist of it all is that your risk appetite influences how much risk you are willing to take, while your risk tolerance determines the level of risk that you can afford to take. And your risk capacity indicates the risk that you must take to meet your goals.
If your risk appetite is higher than your risk tolerance, that could be a bit of an issue because it means you are willing to take on more risk that you can afford to. You need to keep your risk tolerance in sight and not take on more risk that you can handle.
In this case, you can afford to take on more risk that you are willing to. However, you need to account for your risk capacity and see if that additional risk is necessary before taking it.
If your risk tolerance is higher than your risk capacity, it means that you can afford to take on more risk that you need to. That may be a good thing, as long as you are comfortable taking on more investment risk.
If your risk capacity is higher than your risk tolerance, it means that you need to take on more risk that you can afford to. This is not a financially savvy move. The alternative would be to set more realistic financial goals and work towards achieving them.
If your risk appetite is higher than your risk capacity, it indicates that you are willing to take on more risk that you need to. However, you need to also account for your risk tolerance and check if you can afford to take on the extra risk, in the first place.
If your risk capacity is higher than your risk appetite, it means that you need to take on more risk than you are willing to. This may not always be a good thing, because even if you can afford to take on a higher level of risk, it may leave you anxious and worried. An alternative is to adjust your financial goals so that you need not take on such high risks.
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