Understand your true risk profile before investing!

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A common thing we get to hear from all investors is that their goal is to maximise their returns. They want high returns but when enquired about the amount of risk they would be willing to take, draws a vague reply! Some say risk should be less, others say if it’s manageable risk then only, etc. But the fact is most investors do not understand their true risk profile! Understanding your true risk profile ensures that your investments in the long run yield optimum returns.

 


The obvious question which arises now is – how to measure my risk profile?! Well you will find several risk profile questionnaires online for the same.  Your financial advisor too may be asking you to fill in a risk profile questionnaire before advising you on investments. But is this enough? Well we need to first understand what is actually measured in these questionnaires. These help the advisor to judge you on your willingness to take risks. Please understand this different from your ability to take risk.


Willingness to take risk basically means if you had to take a certain amount of risk for a defined return, how much risk would you take. So you may be rated as an aggressive, balanced or conservative investor based on the risk parameter options you chose in the questionnaire.


Ability to take risk however relates to the amount of risk you can actually take. This is judged by mainly three parameters, time-frame for important financial goals, personal circumstances of the investor & the net-worth of the client. You may surprised to know this is not what most financial advisors or banks keep in mind before dishing out investments to you. Several leading financial planners however do.


Let’s understand the difference between the two with a few examples. Mr X wants to invest Rs 10 lacs. He approaches a bank, who duly ask him to fill risk profile form & as per results he is rated an aggressive investor. The bank advises him to invest in an aggressive PMS scheme of theirs. He is willing to take huge risks but does he have the ability? For this let’s understand his background. He is a middle-class employee of a manufacturing firm. He has a wife & two kids. Kids will be entering college in next 2 years. He doesn’t have too many investments as the family has had a modest income till then. His major assets are his residence & Honda Activa (which are personal assets). His EPF is his next biggest investment, this too because it is a forced investment from his employer. The corpus he wants to invest has been received as a share of an ancestral property sold. He needs to fund his children’s education in 2 years & his own retirement in next 4 years. Also in case of his unfortunate demise, what happens to his family as he is the sole bread-winner. Does he look like an aggressive investor now? His ability to take risk is negligible.


On the other hand we have Mr Y. He is a true HNI. His assets are worth more than Rs 100 crores, which is excluding his residential property & 3 luxury cars. A wealth manager approaches him to offer his services. He agrees to try out the same. The wealth manager asks him to fill in a risk profile questionnaire, the result of which is that Mr Y is a conservative investor. He should ideally invest in Fixed Deposits & Government Schemes!! But if such was the case then I’m not sure how he became an HNI in the first place or if he will remain one if he invests mainly in instruments which give low returns. His willingness to take risk may appear low but his ability is immense. Even if he invests Rs 1 crore in the riskiest asset available he is just risking 1% of his networth. Whereas Mr X investing Rs 10 lacs in a moderately risky PMS is risking 100% of his investments! Your ability to take risk is more important to understand than your willingness.


Do chalk out your financial goals & the time horizon to realise whether you can invest in high-risk & high-return assets. If you need funds in 2 years time, equity should not be in your allocation. Your circumstances & net-worth do matter too. Keeping this in mind you can know how much can you risk for a given higher return. A risk profile questionnaire has its benefits but it does not give you the complete answer. Consulting a reputed financial planner will surely help you. We at Fpguru.com have always strived to educate clients on understanding their true risk profile!!

 

The article has been written by Jai Adiani. The writer is the founder  of Fpguru.com


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