Everyone seems to be a risk-taker as long as the markets keep moving in the upward direction. But the moment markets start going downwards, the real risk profile comes into picture. Before moving to risk profiling and asset allocation as per your goals, a few important points must be understood. Having said that, let’s start by discussing what is the risk-taking ability and willingness to take risk in risk profiling.
What Is Risk Profiling?
Risk profiling is a combination of one’s overall risk-taking ability and willingness to take risk.
What Is Risk-Taking Ability?
In simple terms – Risk-taking ability refers to the ability of an individual to take risk.
The risk-taking ability depends on a number of factors. These include your age, nature of the occupation, financial responsibility, number of earning members in the family, nature of accommodation etc. More or less, the risk-taking ability is influenced by internal factors.
Let me give you an example – A person earning 20 Lakhs annually may not get affected by the underperformance of his/her investments worth 2 Lakhs. But a person earning 4 Lakhs annually would be greatly affected by the underperformance of his/her investments worth 50,000.
Risk taking ability of a 50 year old person will be less compared to a person at age 30. If you are on a shaky job or into business with irregular income, your risk taking ability can be less. If you are the only earning member in the family with more dependants, your risk taking ability will be less.
Normally, the risk-taking ability is divided into 3 categories –
- Cautious
- Moderate/Balanced
- Aggressive
What Is Willingness To Take Risk?
In simple terms – The total risk I’m willing to take is the willingness to take risk.
The answer is indeed very tricky because our willingness to take risk is influenced by many external factors. When the markets perform well, even risk-averse investors start investing in the markets. But when markets don’t do well, even risk-takers begin shifting their portfolios towards debt instruments in order to avoid losses.
Willingness to take risks is a personal trait. It depends on external factors like peer pressure, our past experience, expectation of returns etc.
Let me give you an example – Some HNI investors don’t like fluctuations in their portfolio and hence, they invest in debt instruments. While some people with modest income invest in equity instruments.
Normally, the willingness to take risk is divided into 4 categories –
- Cautious
- Moderate/Balanced
- Aggressive
- Very Aggressive
Risk Profiling and Asset Allocation
Risk profiling and asset allocation go hand in hand.
But the question is that can the asset allocation be done solely on the basis of risk profiling? The answer is a big NO.
There’s another factor that comes into play here – Your Goals.
For example, consider that you’ve a goal which has to be achieved in 3 years’ time. Now suppose both your risk-taking ability and willingness to take risk fall in the aggressive category. Can you take the risk to invest in equity instruments for this goal in such a situation?
The answer is No even though you’re an aggressive investor. The investments should be in debt instruments regardless of the investor’s risk profile.
So, it’s very important to check the duration of your goals for asset allocation in addition to risk profiling.
There can be another flaw in risk profiling when the markets are continuously moving in upward directions. Even a cautious investor would try to invest in equity instruments when the markets are going up. The willingness to take risk may not show a true picture in the risk profile questionnaire.
Also, an aggressive investor may start moving towards debt instruments when the markets are falling continuously. Similarly, the willingness to take risk may not show a true picture in the risk profile questionnaire.
In such a scenario, the willingness to take risk is assessed considering the previous investment made by the investor. For example, suppose there’s an investor who has an equity/debt ratio of 20%/80%. And, he/she has been investing for the last 15 years and seems to be a cautious investor. However, the risk profiling questionnaire may be showing the person as an aggressive investor.
Even a young investor who has just started investing with an aggressive risk profile shouldn’t invest 100% in equity. The reason behind not investing 100% in equity is that – the young investor might be unable to handle the sudden downfall in the market. He has to experience a market crash to see how he reacts to the volatility.
Risk Profiling Questionnaire – Download
You can download the risk profile questionnaire in excel here and fill in the options in Column H (marked in yellow).
The results will show in Column Q. First 7 questions show Risk Taking Ability and last 8 question show willingness to take risk.
Conclusion
There is no quick fix solution for asset allocation based on risk profiling. The duration of your goals needs to be taken into consideration while suggesting asset allocation in addition to risk profiling. An aggressive investor may be asked to taper down the expectations and move from equity investments to debt instruments. (If the goal is just 2-3 years away.) At the same time, a cautious investor could be asked to increase the equity portion of his/her investments. (If the goal is 20 years away.)
This was all about risk profiling and asset allocation. Do let me know if you have any queries.