What is a Risk Profile?
Updated on 24 Feb 2020
An investor’s risk profile is part of their financial DNA. In order to build the profile, there are two major things to consider, the risk tolerance and the risk capacity of the individual. The following article gives you an in-depth understanding of these two concepts.
A risk profile refers to an individual investor’s ability and willingness to take any risks with their investments. Understanding an investor’s risk profile is extremely important because it helps financial advisors have a clearer picture regarding the right investment for their portfolio.
Investors will low risk profiles will always be directed towards much safer investment avenues that come with a lower yield, as opposed to investors that have a higher risk profile. theFor latter, financial advisors would direct them towards high-risk, high-ROI investments such as blue-chip funds. In this article, we’ll tell you everything you need to know about risk profiles.
In order to build an investors risk profile, there are two major things to consider. These are the risk tolerance and the risk capacity of the individual. We explain these in detail below.
Risk Tolerance and Your Risk Profile
The term risk tolerance refers to the degree of risks that a particular investor feels comfortable taking. In other words, it refers to the amount of uncertainty that the investor is okay facing. As there is no financial investment that is absolutely risk-free, all investors do make their peace with the fact that they will have to face some risk. But, the volatility that they are okay with tends to vary from person to person. Therefore, financial advisors chart out risk profiles for every single investor that they work with.
Determining Your Risk Tolerance
Risk tolerance can vary greatly with age, income, goals, and existing investments, and most investors fall into one of the following categories:
- Very aggressive
- Very conservative
One of the most common predictors of risk tolerance that advisors see is age. Young investors who are just starting out their investment journeys are more likely to be willing to take some risks to get better returns. On the other hand, older investors reaching retirement would like to see their wealth grow by taking conservative steps.
There are also certain personality traits or behavioural traits that align with each of these categories. These are:
Aggressive: tend to be well-aware of what’s happening in the market. They understand both, securities and their propensities, which is what lets them purchase volatile financial instruments.
Balanced: tend to favour a 50/50 approach when it comes to their investments. They are willing to accept a certain level of risk, but not more, and always end up picking intermediate term horizons for their investments, like 5-10 years. The right approach for such investors is to combine large company mutual funds along with risk-less securities and less volatile bonds to help them feel a bit more secure about their funds.
Conservative: tend to be highly risk-averse and will not accept investments that have high degrees of risk. Such investors are okay with the idea of getting low returns on investments, as long as they get to feel that their funds will be secure in the long term. Conservative investors also prefer investments that very liquid in nature. An example of the kinds of investments such investors would choose includes US Treasury funds, money markets and certificates of deposit. They may also favour investments like real estate.
Risk Capacity and Your Risk Profile
While risk tolerance refers to what individuals are comfortable with, risk capacity, on the other hand, refers to the risk they have no option but to endure. All investors have certain goals in mind with regards to the growth of their funds, and these goals often align with different financial products, which come with their own degrees of risk. Therefore, in order to meet these goals, investors must expose their funds to the risk involved.
Balancing the Two
An investors risk profile is typically made by balancing the two risks to come up with options that align risk tolerance with capacity as seamlessly as possible. Doing so helps financial advisors then pick out the right investment avenues for their clients, thereby creating a list of options that help clients get everything they want. This is why when it comes to investments, the first thing that you must identify is your own risk appetite. Once you do so, you can go ahead and figure out your investment goals – which will give you a clear idea about the risk capacity that you must endure.
When you are starting out your investment journey, it is very important to understand your volatility levels. If you’re the kind of person that gets anxious very quickly and always imagines the worse, then you probably should not pool all your funds in high risk investments! On the other hand, if you are willing to take risks to a huge payout at the end, then you can go for high risk investments without batting an eyelid.
Speak to our experts at Kristal.AI to know more about your risk profile, and the investments that are perfect for you!
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