The Importance Of Risk Profiling

Any Financial Planner worth his or her salt will tell you that a proper assessment of your risk profile is the first and foremost step in the creation of a robust Financial Plan. If you're not aware of your own Risk Profile, chances are you'll end up taking regrettable investment decisions at least a few times in the future.

According to Sudipto Roy, Managing Director, Principal Retirement Advisors Private Limited, Risk Profiling is a great starting point for your journey towards sustainable wealth creation. "Risk Profiling helps you invest in the optimum and diversified asset allocation, and helps you plan for investing in different goals", he says.

What is Risk Profiling?
No two people think and act in the exact same manner. Especially when confronted with decisions or crossroads, one's reactions tend to be conditioned by their attitudes, mindset, past experiences and current situation, among other things.

"You need to be comfortable with the risk that you are taking while choosing a specific asset class. If you are uncomfortable with the volatility that is observed in some of the riskier asset classes, it is advisable to invest as per your stated Risk profile", says Roy.

Risk profiling aims to simplify the process of understanding your underlying attitudes towards investing, and hence predicting your probable reactions to future events (for instance, when markets collapse: are you likely to stay put, buy more or sell out in panic).

Your Risk Profile in itself can be thought of as being composed of two distinct elements. The first, your Risk Appetite, concerns itself with your mindset of psychological attributes and how they might affect your future investing behavior. Mock-situational questions or your probable reaction to simulated events (for instance: if you win a Crore in the lottery, what would you do?) help your Financial Planner determine your Risk Appetite.

The other element - your Risk Tolerance, depends upon your current life situation more than anything else. For instance: your age, number of dependents, monthly income and size of emergency fund, among other things, will be key determinants of your Risk Tolerance level.

Your Risk Profile is a composite of these two elements, and is measured using a score that could range from 1 to 100 or 1 to 10, depending upon the questionnaire you're taking.

Why is it important?
Truth be told, you never really know how you'll react to a particular market situation unless you're actually there. Precipitous market falls have stripped many a so called 'courageous' investor of their ability to hold on to their stocks, let alone invest more money into falling markets. Proper Risk Profiling ensures that your asset allocation (read: balance between 'higher risk' and 'lower risk' assets) is in alignment with your attitudes and current situation. This will allow you to take wiser decisions with your money (i.e not panic and sell out or invest out of greed). In the long run, you'll be happy with the returns you've earned.

"The rate of return that an investment is going to generate is generally the first thing that is discussed at the time of investment", says Roy. "While this is definitely a very important aspect to be noted, it is equally important to consider the risks associated with that particular investment"

How is it done?
Your Risk Profile is determined using a questionnaire. Some questionnaires are short (under 10 questions) while some can be as long as 30 questions. The more detailed it is, the more it's likely to capture your Risk Profile accurately.

According to Roy, there are three key determinants of a high quality Risk Profiling quiz. "The Risk profile of an individual will be determined based on a questionnaire which tests the investor's responses to her limitations in taking financial risk, past decisions in financial situations, and her attitude towards investing in various risk - return scenarios", he observes.

Can it change over time?
Your Risk Profile can change over time. Things like a change of job, an increase in your dependents, and the death of a spouse amongst others can all influence your Risk Profile materially. It's best to re-evaluate it once a year to stay on top of things.