What is Risk Profile in investing and how is it measured?


What is Risk Profile

Risk profile is a measure of how much risk should one be taking in one's investments considering all the factors like one's financial situation, need and attitude towards losses.

Since most of these factors are personal, risk profile varies from individual to individual.

Before we get into the details of how Risk Profile can be measured, let's quickly understand why is it so important.

Why is Risk Profiling needed?

Risk profile determines how you should split your money into risky investments like Equity Mutual Funds and non-risky investments like Debt Mutual Funds or FD.

Why can't we just take a lot of risk and invest when markets (and hence Equity Mutual Funds) are going to go up and reduce risk and exit when they are going to go down?

Because it is almost impossible to predict when the markets are going to go up and when they are going to go down.

Even when markets have been going up for a few months or years, any month can turn out to be the top and markets can start going down from there.

Look at the chart below of Nifty. The market is obviously going up, right? Let's load up on risk.

Nifty-2018-going-up

This is what happened immediately afterwards:

Nifty-2018-going-down

And no one can predict this with confidence repeatedly.

Similarly, even if the markets have been going down for a while, any month can turn out to be the bottom and the markets can start going up after that.

Turning points are unpredictable. Hence we don't have the luxury to dial the risk up or down based on market conditions.

You are flying blind if you are investing without knowing your risk profile.

The best option we have is to assume that the markets can crash anytime and hence invest only according to our risk profile.

Methods of assessing Risk Profile

Rules of thumb

There are some popular rules of thumb for determining asset allocation or risk profile of which the one below is the most well-known:

Equity % = 100 - Age 

i.e. if you are 20 years old, then Equity % should be 100-20 = 80%
There are also variations of this, eg 120 - Age etc.

Another rule of thumb is to just split it equally i.e. 50-50.

More often that not, these rules or defaults are too simple to be of much use and can lead to excessive risk taking.

Risk Profile Questionnaire

A Risk Profile Questionnaire is a set of questions that have been thoughtfully framed to uncover the various factors that determine an individual investor's risk profile.

It is not a quiz or test in the sense that there are no right or wrong answers. As long as you are answering truthfully, you are being correct.

Based on the responses to the questions, either an objective scoring method or a human advisor computes the Risk Profile of the investor.

Usually Risk Profile Questionnaires measure Risk Profile as Low, Moderate or High rather than specific Equity-Debt % allocations since the exact allocation would depend on a lot of other things (time horizon and purpose of the goal for eg).

It is a more comprehensive and useful way of measuring risk profile of investors as compared to simplistic rules of thumb.

As an example here is a link to Goalwise's Risk Profile Questionnaire.

goalwise-risk-profile-questionnaire

Components of Risk Profile assessment

There are three components of an individual's risk profile:

  1. Capacity to take risk
  2. Risk tolerance
  3. Need to take risk

All three together determine the risk profile of an investor.

Let's unpack each of them:

Capacity to take risk

Capacity to take risk or Risk Capacity is simply a measure of how much risk you are capable of taking given your current financial situation.

(Note: Just because you are capable of taking a particular risk does not mean that you should.)

Your financial situation involves the following:

1. Age

Age plays a huge role in your capacity to take risk. Younger investors have a longer time horizon to invest for and they also have an income stream that will keep increasing for a long time. Hence, they can take more risks than older investors who might be looking to conserve wealth as they near retirement.

2. Nature of income

If your income is unpredictable (eg freelancers, seasonal income sources) then your ability to deal with losses on your investments will be low. However, if your income stream is predictable and upward trending, then you can take higher risk with your investments.

3. Amount of savings till date

If you don't have enough savings then taking high risk with whatever little amount you are saving is not be advisable. Typically, higher the savings, higher the risk you can take.

4. Dependents

If there are people who are dependent on your income (eg retired parents, non-earning spouse), that constrains your ability to take risks in life. Same applies to your investments as well. On the other hand, if you and your spouse are boh earning and your parents are not dependent on you, then you can take higher risks given other factors are also aligned.

Capacity to take risk is just one of the components of your risk profile. Just because someone has a high capacity to take risk because of her sound financial situation does not mean she can stomach that risk.

Risk Tolerance/Appetite

Risk Tolerance or Risk Appetite or Preference for risk measures your psychological attitude towards risk and losses.

Do you start feeling worried when you see losses or you can take them in your stride?

How much money can you lose without losing your sleep?

This is the most difficult to judge aspect of risk profile because it deals with emotions in a hypothetical situation.

You can't really know how you will react to losses unless you are actually in that situation.

Behavioural economists have found that the pain of loss is at least twice the pleasure of a gain of similar amount.

Because of this most people over-estimate their ability to deal with losses.

Investors investing under a high risk profile pinging us on chat worried after a 5% loss is not uncommon at Goalwise.

Risk tolerance is not static. People change and so do their attitudes towards risk. Some of the factors that affect your risk tolerance are:

1. Knowledge

Warren Buffett said - "Risk comes from not knowing what you are doing."

risk-comes-from-not-knowing-what-you-are-doing

So one of the ways to reduce your risk (or increase your risk tolerance) is simply to get to know more.

Just like knowing how parahcutes work gives some people confidence in jumping out of an airplane, knowledge about how investments work and their past behaviour can give you greater confidence in investing, there by increase your risk tolerance.

2. Past experience

Once you have gone through a complete cycle of markets ups and downs without panicking, you will see that it eventually does work if you stick through. Then going forward it will become easier for you to stay put in the face of losses.

If you have never invested in Mutual Funds before or have not been through a down cycle or market crash, it is better to assume you don't really know how much loss you can tolerate before pressing the panic button.

So what should you do?

Our (very scientific) suggestion: Halve it!

If you think you can take a 30% loss, assume you can take only a 15% loss. Then once you are in that situation actually facing a 15% loss, you can see how you are feeling and re-assess.

Need to take risk

Capacity to take risk and risk tolerance are the two major components of your risk profile but there is one more aspect that needs to be taken into account - your need to take risk.

Imagine that you have a high capacity to take risk and also have a high risk tolerance but all your financial goals are already complete. You can just keep your money in a savings account or FD then. There is no need to take any more risk.

Although this is an extreme case, but if you start early, save a lot and plan well, you can get to a stage in life later where you would have enough so that there will be little need to take on much risk.

How to combine Risk Capacity, Risk Tolerance and Need to take risk

This is the most important part of determining one's risk profile.

Most questionnaires just take an average of the score on different components of risk profile.

E.g. If you have a high risk taking capacity (because you are young, have no dependents and a stable job), low risk tolerance (don't really like the idea of seeing your investments in a loss) and moderate need to take risk (your financial goals won't be met just by saving), your risk profile will be computed as an average of high, low, and moderate i.e. moderate.

However, taking an average is not the best approach. Just like you can drown in a swimming pool that is just 5 feet deep on average, you will end up panicking when a crash occurs if you invest with a moderate risk profile since your tolerance was low (capacity and need notwithstanding).

A better way then is to use all the components as limiting factors i.e. take the minimum of the three components - if you have high capacity to take risk, low risk tolerance and moderate need to take risk, your risk profile is low.

This is also the approach that we take at Goalwise in our Risk Profile Questionnaire.

Want to know your Risk Profile?

You can take the Goalwise Risk Profile Questionnaire here to know your risk profile for investments.

Not investing according to their risk profile is the number one mistake that most investors make. Make sure you are not one of them.