Mutual Fund Unlocked: How to assess your own risk profile?

Knowing your risk profile remains at the centre stage of any investment. Without knowing your risk profile, you may go for investment that is not suitable for you. Especially in the case of mutual fund investment, one scheme cannot be claimed as suitable for all. Suitability of a product largely depend upon the characteristics of the investor. Hence, risk profile means understanding your investment traits. This can be a combination of factors such as your age, habit, behaviour, family, attitude towards risk etc. Knowing your risk profile will help you design the right asset allocation and choose a correct style of investment.

There are various theories on knowing your risk profile, however, everything boils down to two things.

·         Risk Capacity

·         Risk Aversion

Risk capacity refers to your ability to take on financial risk. It will depend upon your economic circumstances, such as the investment horizon, liquidity needs, income, and wealth, as well as tax rates and other factors. Your risk capacity has nothing to do with your behaviour or psychological factors. It is purely an objective consideration.

Risk aversion is where the subjective consideration creeps in. It considers the psychological traits and emotional responses that determine the investor’s willingness to take on financial risk. Many a times your risk aversion or risk tolerance takes the driver seat in making investment decision. The most important age bracket when these preferences are formed is between age 16 and 25. These are precisely the years when one starts investing. Your experience in these years go far in forming your risk tolerance level.

The combination of the above two factors is what better known as risk profile of an investor. Any investment is suitable for you only if it falls within the preview of both your risk capacity and risk aversion or tolerance.

Once you understand your risk profile you can go for appropriate asset allocation, which decides what portion of your investment should go to which asset class.

The spectrum of risk profile goes from very low risk to very high risk. Depending upon what part of risk spectrum you are lying, you can allocate your investment into 100 per cent debt and cash to 100 per cent equity, respectively.

One thing to remember is that your risk profile changes according to change in your life cycle and hence your investment and asset allocation should also change accordingly.