By Nidhi Manchanda

Knowing one’s risk appetite is a very crucial step before starting an investment journey. However, solely depending on it to make all investment decisions is also not advisable. There is a way to use it to the best advantage and this article will guide you with the “How” of it all.

But, before we bust the biggest myth of “Investing only as per your risk appetite”. Let us first start from the basics.

How exactly can you find out your risk appetite?

The most popular way of doing it is by answering a risk profiling questionnaire. This questionnaire is framed in such a way as to find out your risk-taking capacity and risk tolerance.

Risk-taking capacity will depend on factors like age, income, the number of dependents, etc. Risk tolerance on the other hand is mostly understood by asking questions like, “How would you feel in case your investments go down by 20% or more” or “Will you still stay invested? Or will you withdraw to limit your losses?”

Answers to these types of questions would give an idea of whether a person has high-risk tolerance or low-risk tolerance.

Understanding different Risk Profiles

Well, if one is doing investments for some time, he or she must have come across these risk profiling questionnaires which determine an investor’s capacity to take risks and one’s overall behaviour towards risk. The output of these risk profiling questionnaires will typically inform the individual which out of the below five risk profile is theirs;

  1. Highly Aggressive
  2. Aggressive
  3. Moderate
  4. Conservative
  5. Highly Conservative

Usually, based on the risk profile, an asset allocation is suggested to an investor. A highly aggressive investor would be recommended to invest 100% of the money in highly risky investments like the share market, PMS, small and mid-cap stocks, or sector-specific exposure. 

But, is it right to invest 100% in highly volatile assets even if he is a highly aggressive investor? Are we assuming for short-term goals also, should one be investing in highly volatile assets?

Similarly, a highly conservative investor would mostly be recommended to invest only in low-risk investments like FDs, RDs, PPFs, Debt Mutual funds, etc. 

But shouldn’t we encourage such an investor to have some equity exposure for long-term goals and educate the investor that it is difficult to beat inflation when continuing with low-risk – low-return investments? Going against one’s risk profile outcome from these questionnaires may help in creating wealth.

So, there are challenges in following the risk profiling questionnaire directly as the first step. Some of these challenges are;

Two Major Challenges with this approach

1. Investor biasedness – While answering a typical risk profiling questionnaire, do investors mean what they are answering? Talking with people’s experience of dealing with clients, most people say they are not ready to take very high risks although they want higher returns. Also, investors who told their financial planners that they are highly aggressive, end up withdrawing their money after looking at markets going down by 10-15%. Are they highly aggressive? It’s also true another way around for conservative investors. Also, many a time, the investor himself is not sure about his risk tolerance, especially the new investors. 

2. Avoiding investment horizon – In case an individual gets a highly aggressive risk profile as an outcome because he or she is young, has no dependents, etc. The asset class suggested would be majorly equity. However, what if most of the goals of that particular individual are near-term and priority? It is not suggested that one invest in highly risky investment options like equity markets for a 1-year goal. Even if the investor is asked about investment time horizon in risk profiling questionnaires, he is limited to selecting only one option. Goals could be ranging from 0-30 years and the quantum of goals could also be very different.

Owing to the above two challenges, one should not follow risk profile blindly as the only step to deciding asset allocation as part of investment strategy.

So, what are the solutions and the right approach?

Although knowing one’s risk appetite is important but just investing as per their risk appetite is not a very wise choice. Follow the below steps.

Step 1 – List down your goals

Make a list of all the financial goals that one would want to achieve in the future. It could be buying a vehicle, a house, going on vacations, higher education, children’s education or marriage, retirement, etc. 

Step 2 – Create 3 buckets of Short term, Medium Term and Long term goals

After making the list of financial goals, beside each goal write the time horizon to achieve each goal. Sort all goals into 3 buckets – short-term, medium-term and long-term goals.

Short-term would be the goals which are up to three years. Medium-term goals would be the ones that are falling between 3-5 years. Any goal which has a time horizon of 5 years and above, is put in the long-term bucket.

Step 3 – For each goal basket, create a risk profile 

An individual cannot have just one risk profile, instead one should be taking different levels of risk as per different financial goals. Short-term goals basket should have low-risk investments. Medium-term goals are suggested to be met by medium-risk investments. Have exposure to high-risk investments like equity asset class for the long term.

Investor’s risk appetite will play a role here. Let’s say in the long-term goal, a person with a conservative risk profile should invest in index or large-cap equity mutual funds, and one with an aggressive risk profile is recommended to invest in fundamentally strong small-cap stocks. 

Based on this, create an asset allocation strategy i.e. how much to invest in equity, debt, gold, real estate, and alternate assets. 

Step 4 – Check your overall asset allocation 

The last step would be to check if the individual is not overexposed to one particular asset class. If yes, the person should make a few changes in consultation with the financial planner.

All of this may sound complex and thus it is highly recommended to consult a finance expert for assisted financial planning services to take care of all of this and much more. Just checking risk profiles online and starting investing may not be the best and wisest decision.

So, use risk profiling the right way. 

(The author is a Certified Financial Planner and Head of Training, Research & Development at Fintoo. Views expressed above are those of the author and not necessarily of financialexpress.com)