Risk Profiling

We use various financial instruments to meet our various needs.

We use bank accounts to facilitate to deal with money, with credit card and wallets to make payments easy, loans to meet some financial obligations etc.

We use various Investment Products so that so that we can save money today to reach future financial goals.

By doing this, we are trying our best in getting ready today for tomorrow.

When it comes to investing, along with return expectations, we also have to keep in mind about risk.

We already have dealt about the aspect of risk in our lesson on Investment Risk and its Measurement.

In this lesson, we shall deal in a little more detail about Risk Profiling aspect of the Investor.

What is Risk Profiling?

Risk profiling is an approach to understand the risk appetite of investors.

This is an important and essential activity to be done by the investor before he goes ahead with shortlisting investment products.

There are two aspects to consider in this activity:

1. What is the Risk appetite of the investor

2. What is the Risk level of the investment option being considered

Factors affecting risk appetite

Different factors have a different degree of influence on risk appetite.

Family Information

1. Earning Members

Risk appetite increases as the number of earning members increases

For example, if sons of the family get employed and start earning, the family might consider taking higher degree of investing.

2. Dependent Members

Risk appetite decreases as the number of dependent members increases

For example, a family with one young child takes more risk over a family with two young children.

3. Life expectancy

Risk appetite is higher when life expectancy is longer.

We know this by looking at the risk appetite of young investors because they have a long time in terms of age to fix up any mistakes or hurdles if they encounter.

Personal Information

1. Age

Lower the age, higher the risk that can be taken

Young investors prefer growth oriented instruments such as Equities while retired and senior citizens would prefer income-generating instruments such as bonds.

2. Employability

Well qualified and multi-skilled professionals can afford to take more risk

For example, an IT professional would take higher degree of risk over an employee in a small private firm.

3. Nature of Job

Those with steady jobs are better positioned to take risk.

For example, an employee who has a salary job is more likely to take monthly investment commitments over a businessman whose earnings flow would be adhoc.

4. Knowledge about markets

A person who is better informed about markets is in a better position to take market risks, than someone who is ignorant about them.

5. Psyche

Daring and adventurous people are better positioned mentally, to accept the downsides that come with risk

Financial Information

1. Capital base

Higher the capital base, better the ability to financially take the downsides that come with risk

2. Regularity of Income

People earning regular income can take more risk than those with unpredictable income streams

Role of Investment Adviser

An Investment Adviser need to consider all these aspects implicitly and explicit before giving any investment advise.

It is obvious that the conversation between the adviser and the investor would start with:

"How much risk are you prepared to take?"

Secondly, the time horizon for the investor financial goal is very important and appropriate instruments will have to be selected.

For example, for near term and short term goals, such as paying school fees due in a couple of months, it is wise to use a debt instrument over an equity instrument.