Know Your Risk Profile before Investing

One's risk profile is not constant and changes over time, with age, increasing responsibilities and life circumstance

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It is important for investors to understand their risk profile before building an investment portfolio. A risk profile typically depends on a person’s age, life goals and duration of the investment. Depending on these a person can have different risk levels.

At a young age, when retirement is decades away, investing for the golden years of life is a long-term goal and greater risk can be taken to achieve potentially higher returns or capital gains. Age gives young investors the advantage of riding out the highs and lows of the market. On the other hand, if one is nearing retirement, it is better to go for less volatile, maybe even lower yielding assets so as to minimise the risk of any sudden dip in the total value of investments.

Duration of an investment can be divided into three types – short term, medium term and long term. Short-term investments can be between six months to two years; medium term from two to four years; and long-term from four years onwards to over 10 years.

Saving for a trip abroad in the coming eight or nine months is a short-term investment and one would need the money at that very juncture. Saving to buy a car in two years’ time is an example of a medium-term investment. Retirement is usually a long-term investment.

A clearly defined risk profile helps to find investment solutions that meet one’s goals.

Broadly, risk profiles can be divided into three types:

Conservative or low risk

Under this type, an investor prefers stable investment and focuses less on capital growth. Stable investments grow gradually in value and are less volatile. Debt-oriented mutual funds suit this type as it gives a steady income stream and moderate capital growth.

Balanced or medium risk

This suits investors who are ready to take on some amount of volatility but are averse to too many twists and turns. Since the thumb rule with risk is that the higher the risk the higher the return, this profile could provide good capital growth over the long term. A balanced mutual fund scheme that invests in both equity and debt fulfils a medium-risk investor’s needs.

Dynamic (high risk)

Dynamic investors are those who don’t mind exposing their portfolio to greater risk and higher volatility. This enhances the chances of maximising capital growth. Equity-oriented mutual fund schemes are best suited for this profile, and a small portion could be invested in fixed income.

Thus, based on these parameters one can ascertain the risk profile. Often the mistake investors make is they don’t match their investments with their risk profile. For instance, investors who claim to be aggressive invest only in debt schemes and shy away from equity schemes because they don’t want to take up the extra risk. The ones who call themselves conservative investors have actually delved into equity pure play, not realising it’s for aggressive investors.

Make an informed decision by first sketching out your goals and then matching the risk profile. Also, one’s risk profile is not constant and changes over time, with age, increasing responsibilities and life circumstances. So, one should review from time to time and make changes accordingly.