Do you know that the risk profile of an investor varies depending on several factors? Now you are likely to be aware of this disclaimer: ‘Mutual funds are subject to market risks,’ but are you aware of the different kinds of market risks which could hurt your investments, and, in the process, your financial goals? Also, do you know which mutual fund category is best suited to your risk profile? To know the answers, it’s essential to understand what is risk profiling and what are the different types of risks associated with your mutual fund investments which should help you in determining how investment much risk you should take.
What is risk profiling?
Risk profiling is the knowledge about your risk-taking capacity to ascertain how much investment risk you need to take in order to timely accomplish your financial goals. Several factors impact the risk profile of an investor, like age, income, existing financial commitments and debt situation, goal size, time in hand to achieve the goal, liquidity needs, etc. Now if you are planning to invest in a mutual fund scheme, understanding your risk profile can also help you to identify the right category of funds for yourself.
A mistake in risk profiling can lead to an adverse result. For example, let’s assume an investor is looking to achieve a goal that requires a substantial corpus in 1 year. Since this is a short period of time, it would be advisable to invest through low-risk investment tools such as fixed deposits or liquid mutual funds. Volatility in the short-term could harm the achievement of the goal if the investment were done through a high-risk investment tool such as equity.
The risk profile of investors is usually categorized into five levels: conservative for a low-risk profile, moderately conservative for moderately-low risk profile, moderate for moderate risk profile, moderately aggressive for a moderate high-risk profile, and aggressive for the high-risk profile. An investor can select the investment instrument that carries risk corresponding to their risk profile category.
Risk profiling procedure
Risk profiling entails three steps i.e., knowing your risk capacity, estimating the risk requirement to achieve your goal, and knowing your risk tolerance.
Risk capacity shows the maximum risk that an investor can afford to take to achieve a specific return level so that the goal can be reached within the expected timeframe. Risk requirement is the level of risk one needs to take to achieve the goal. Depending on the level of risk requirement, one can identify suitable investment products for achieving the goal. Risk requirements may vary depending on factors like the age of the investor, size of the financial goal, investment size, etc.
Risk tolerance, on the other hand, is the level of risk that one is ready to take when investing. This is determined by factoring in things like the investor’s current debt level, existing financial commitments, insurance coverage, etc. Risk tolerance shows the level of price fluctuation and volatility that an investor is ready to bear for achieving the goal. As such, an investor can draw an investment plan for achieving the goal once he knows his risk capacity, risk requirement, and risk tolerance. In fact, there are guidelines set by the Securities Exchange Board of India (SEBI) and the Association of Mutual Funds in India (AMFI) that a registered investment advisor has to follow for assessing the investor’s risk profile.
Types Of Risks That You Should Be Aware Of While Investing In A Mutual Fund Scheme
Each mutual fund category has different types of risk associated with it. For example, the risks associated with debt funds are different from those associated with equity funds. Moreover, within the same mutual fund category, different types of schemes may carry different types of risks. For example, short-term debt funds may carry risk different from those of long-term debt funds. Small-cap equity funds have higher market risks compared to a long-term equity fund. Some of the common risks associated with the mutual fund’s investment are interest rate risk, credit risk, liquidity risk, inflation risk, price fluctuation risk, concentration risk, etc.
Though you may not be able to eliminate the risks, adopting the right strategy and smart selection of mutual funds can help in reducing the risk to a large extent. Selecting the right fund in sync with your risk profile can help in mitigating investment risk and boost your chances of timely achieving your financial goals. If you find it difficult to lay down a mutual investment strategy that is in line with your requirements and risk profile, don’t hesitate to consult your investment advisor.
The author is CEO, BankBazaar.com, India’s leading online marketplace for loans and credit cards.