How To Assess Your Own Risk Profile
Far too many investors dismiss Risk Profiling as new-age balderdash, only to be caught off guard when markets play spoilsport. But investing without an understanding of risks involved can lead to a very poor experience. What makes matters a lot more complicated is that buoyant markets tend to magically increase risk taking ability, meaning that one can’t fully trust their own subjective self-assessment of their own risk profiles!
Risk Appetite and Risk Tolerance – same difference?
There are two distinct sub-components of what determines your overall risk profile – namely, your risk appetite and your risk tolerance. Both combined go on to form your unique personal Risk profile.
Risk Appetite is more subjective in nature, and essentially refers to an individual’s innate willingness to take on volatility, in the pursuit of investment returns. Age, level of market related knowledge, and past investing experiences all go on to influence one’s risk appetite. The younger and more knowledgeable you are, the higher your risk appetite will be, all things else remaining the same. Typically, a simple introspection exercise will suffice to help you understand your own risk appetite. Risk Tolerance, on the other hand, is more objective – and is a function of some key variables of your life as they stand today. Ask yourself these questions to arrive at your broad risk tolerance level. Remember, both your Risk Appetite and Risk Tolerance are dynamic, and should therefore be re-evaluated periodically.
What is your present financial situation?
In other words, what are your income, expenses, assets, and liabilities? Do you live within your means or do your expenses regularly exceed your monthly inflows, leading to financial leverage? Is your income expected to grow going forward, or are you stuck in a deadbeat job or a cash burning business with no prospects? Are all your assets illiquid and indivisible or can you draw upon them on short notice? Do your monthly outflows on your financial liabilities exceed 30% of your total inflows? In general, the more comfortable you are on the aforementioned parameters, the more risk you can take with your investments.
Do you have an emergency fund in place?
If there’s anything that the pandemic has taught us, it’s the criticality of having a well planned emergency fund in place. A solid emergency fund must have two defining characteristics – one, it should be sizeable enough to help tide you over whatever difficulty you’re facing, and two, it should be easily accessible in terms of liquidity, divisibility and exit costs. A thumb rule is to have at least 6 months fixed expenses as an emergency fund, but 12 months is probably more prudent. The better stocked your emergency fund, the higher your risk tolerance.
What is the length of time remaining until your financial goals?
If you’re at the cusp of your Financial Goals and will therefore require funds soon, your risk tolerance levels would be automatically tempered. If on the other hand, you’re a youngster just starting out accumulating moneys for your retirement three decades away, you can afford to be a lot more aggressive with your savings plans. As a thumb rule, one should start de-risking their investments anything from 3-5 years from their goals, arriving at a zero-risk portfolio by the goal date.
Are your bases covered?
Insurance is a means of transferring risks to an insurer, and paying them to compensate them for the risk transferred thus. If you choose to retain the risks associated with the loss of your life or gargantuan medical bills by not insuring yourself adequately, you’ll need to reduce the risks intrinsic to your investments to compensate for the same - and bring down your total risk exposure. In general, it would be prudent to be covered to the extent of at least 20 times your present net income through term life insurance, and at least 2 lakhs per family member through a floating medical insurance plan. Having this basic risk transfer plan in place will allow you elbow room to be more aggressive with your savings and investments, thereby improving your chances of generating long term wealth from them.
