Chapter 2: Knowing The Unknown: Your Risk Profile
Understand your risk profile to make smarter investment decisions. Learn risk tolerance, asset allocation, and investing strategies for your goals.
I (Abhinav Mishra) published my book, ABC of Investing, in 2023, and it’s been 3 years now. To ensure the learning I have shared in the book reaches a wider audience, I am sharing all the content via this new newsletter. Every week, on Thursday, a new chapter will be released.
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In my WhatsApp groups, many investors ask questions like, ‘Can I invest in ABC mutual funds or Can I invest in XYZ Ltd.?
I never like these questions. If you have been asking such questions on social media and other platforms, you need to stop doing it. Every penny that you invest should be, first, in line with your financial plan, and, second, in sync with your risk profile.
Let me explain with an example. Assume your friend goes to Imagica (a theme park in Pune), which is full of rides (if you are near Pune, I recommend visiting it). He comes back and tells you that he had great fun on the Nitro ride (you can check out a YouTube video to find details of the ride). You are excited to be on the ride, as you already have plans to go to Imagica the following week.
For those who don’t know about this ride, it is India’s biggest and wildest roller coaster. Standing at a staggering 132-foot high with over 2800 feet of track length, Nitro provides an adrenaline rush during the 150 seconds of pure excitement.
You go to the theme park and take the ride. Within the first 10 seconds, you realize you have made a mistake, but it’s too late. The ride is not going to stop for the next 140 seconds. Every second seems like an hour.
You get down. You seem unconscious and feel like vomiting. The damage has been done. The ride impact is so severe that you cannot take any more rides. The fun afternoon has turned into a gloomy day.
Why did it happen? It happened because you just jumped on the ride, assuming you would enjoy it because your friend enjoyed it.
If you have understood the above example, you have figured out why asking questions like ‘Can I invest in ABC mutual funds? or Can I invest in XYZ Ltd.? is a big mistake.
The way to avoid this mistake is to understand the risk profile.
Your risk profile refers to your tolerance for and willingness to take on different levels of investment risk. It reflects your ability to withstand potential losses and your desire for potential returns. A risk profile is determined by various factors such as financial goals, investment horizon, income level, age, investment knowledge, and personal preferences. Understanding your risk profile helps you make informed investment decisions that align with your circumstances and preferences.
I usually break down the risk profile into two parts when explaining it to investors:
Part 1: Risk Tolerance
Risk tolerance refers to your psychological or emotional ability to endure fluctuations in the value of your investments. It reflects your willingness to take on risk and your comfort level with potential losses. Understanding risk tolerance helps you determine the appropriate level of risk you can handle in your investment portfolio.
Suppose there are two investors, Abhinav and Raksha. Abhinav has a high-risk tolerance, meaning he can tolerate significant fluctuations in his investments, and has a long-term investment horizon. He is willing to invest a substantial portion of his portfolio in high-risk assets like stocks, which have the potential for higher returns but also carry higher volatility. He will not have sleepless nights if his investment goes down by 20% or 30%.
On the other hand, Raksha has a low-risk tolerance. She prefers more stable investments and cannot tolerate large fluctuations. If she sees her portfolio down by 10%, her mind gets completely occupied with the loss figure. As a result, she invests a significant portion of her portfolio in low-risk assets such as government bonds or fixed deposits, which offer lower returns but are relatively stable.
Part 2: Risk Capacity
Risk capacity refers to your financial ability to bear losses resulting from your investment decisions. It is influenced by factors such as income, savings, expenses, and financial obligations. Evaluating risk capacity helps investors determine the proportion of the total wealth they can afford to expose to riskier investments.
Let’s consider two investors again: Mr. Abhinav and Mr. Mohit. Mr. Abhinav is a young professional with a stable income and minimal financial obligations. He has a high-risk capacity as he has a considerable surplus income after meeting his expenses and can allocate a significant portion of his savings towards investments with higher risk, such as equity mutual funds or venture capital. In contrast, Mohit is an individual with limited income sources and high living expenses. Also, he is the only breadwinner in the family and has many liabilities. He has a low-risk capacity since he must prioritize consistent income. Vinay is more inclined to invest in low-risk instruments like fixed-income securities or annuities to ensure a steady cash flow without risking his principal amount.
An important point
The risk tolerance part of the risk profile is more or less fixed. If you have a low-risk tolerance, it will remain the same throughout your financial journey - it is in your DNA. However, your risk capacity may change as you progress in your financial journey. For this reason, you need to regularly evaluate your risk profile.
Different types of risk profiles
Type 1: Conservative Investors
Conservative investors have a low tolerance for risk and prioritize the preservation of capital over potential returns. They prefer low-risk investments, such as government bonds, fixed deposits, and high-quality corporate bonds. Conservative investors are typically risk-averse and may be uncomfortable with short-term fluctuations in the value of their investments. They prioritize stability and income generation over significant capital appreciation.
Example: An elderly retiree who relies on their investment portfolio for income and has a limited capacity to recover from potential losses would typically have a conservative risk profile.
Type 2: Moderate Investors
Moderate investors have a balanced approach to risk and return. They seek a reasonable level of capital growth while maintaining a certain degree of stability. They are willing to take on some level of risk but also desire a measure of capital preservation. Moderate investors typically diversify their portfolios across different asset classes, including stocks, bonds, and cash equivalents.
Example: A middle-aged investor with a stable income and a moderate investment horizon who aims for long-term growth while avoiding excessive risk exposure
Type 3: Aggressive Investors
Aggressive investors have a high tolerance for risk and are willing to accept volatility in pursuit of higher potential returns. They prioritize capital appreciation over capital preservation and are often willing to invest in higher-risk assets such as stocks, real estate, and emerging markets. Aggressive investors are comfortable with short-term market fluctuations and understand that higher potential returns come with increased risk.
Example: A young professional with a long investment horizon, high-income potential, and a strong desire for long-term wealth accumulation. They are willing to accept higher volatility in their investments.
It’s important to note that these risk profiles exist on a continuum, and many investors may fall somewhere between two categories or have a combination of different risk profiles based on their investment goals and changing circumstances. For example, my risk profile is moderately aggressive, which means I fall between moderate and aggressive.
How to know your risk profile?
Knowing your risk profile is simple work in today’s world. There are a lot of online tools that help you evaluate your risk profile. You can make use of them and find your risk profile before investing.
However, if you don’t want to do that, you can drop me an email with the subject line ‘Risk Profile’ at abcofinvesting@gmail.com. I will help you know your risk profile.
“Your risk profile is the compass that guides your investment journey, helping you navigate the uncertain seas of opportunity and caution.” Unknown
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About me: In the last few years, I have noticed that many investors struggle with basic investment concepts. To address this, I have started a personalized newsletter offering easy-to-understand, actionable insights to help investors make better decisions. I have written over 5000+ financial blogs and want to share my knowledge and investing journey with you so you can become a confident investor. Join my journey.