How to evaluate risk profile of an Investor
“Mutual fund investments are subject to market risks.” While the market risk in mutual funds is inevitable, the fund management team can mitigate it to a certain extent, with adequate research and analysis. Based on their risk tolerance ability, an investor may be classified as an aggressive investor, moderate investor, or a conservative investor. This article aims to discuss how to evaluate the risk profile of an investor, including various factors that affect it.
Checklist for evaluating the Risk Profile?
The financial advisors may consider seeking answers to the following questions to evaluate the risk profiles of their clients:
• How does the market volatility impact the investor?
The advisors may consider checking out the client’s reaction to the volatile market movements. It becomes vital for the advisors to check if the client can tolerate the market movements, especially the downward trends. If the answer is a strict NO, the investor may be seen as a conservative investor, who seeks stability in the portfolio. On the other hand, if the investor focuses on the long-term investment horizon, it showcases their ability to take risks and may be classified as an aggressive investor.
• What are the expectations of the investor in terms of the returns from the portfolio?
This is another important parameter that may shift the investor classification. It is often said that only the risk-takers may earn high returns in the markets. In other words, the risk-return trade-off tends to have a positive correlation. Someone who expects higher returns from the markets must be an aggressive investor. On the other hand, an investor who gives priority to portfolio stability over returns may be termed as a conservative investor.
• How much time is available to achieve the specified financial goals?
This may be another important factor to determine the risk profile of the investor. The investor may afford to take higher risks if he/ she is investing with a long-term investment goal, as the short-term volatilities may not significantly impact the performance of the investment in the long run. As such, longer the time remaining for the financial goals, more aggressive the investor may afford to be.
While risk-taking ability comes naturally to the investor, the risk profile can change drastically, as the time remaining to achieve the financial goals reduces. In other words, as the financial goals approach closer, the risk-taking ability tends to reduce, and the investor shifts to a conservative portfolio to protect their overall investment portfolio.
Other factors that determine the Risk Profile of the Investor
Apart from the three basic questions, here are a few other factors that may determine the risk profile of the investor:
• The Age of the Investor – Risk tolerance capacity also depends upon the age of the investor, as the risk profile tends to shift from being aggressive to conservative with the increasing age. This may also explain why your grandparents feel more secure and content with traditional investment products, even while they may not be yielding higher returns and are less tax-efficient.
• Income of the Investor – When an individual has higher income, the risk profile may be skewed towards being aggressive, as a higher risk on few investments is not likely to significantly impact the regular cash flows for the investor. On the other hand, if one has lesser surplus income to save and invest, they may feel inclined to invest the surplus in a safe and risk-free investment product.
• Financial Dependencies – When an individual has higher dependencies of other persons, including parents, spouse, children, siblings and other close family members, the safety of the investment portfolio is more important, considering the need to have a financial cushion for any exigencies. On the other hand, a young earner with virtually no dependencies will be willing to take higher risks like investing in a start-up enterprise, etc. Such intent to take high or low risks is what separates an aggressive investor from a conservative investor.
• Emotional Bias – The risk-taking ability also depends on the emotional bias attached to the financial goals. While an investor may not be willing to take higher risks for the goals related to their child’s education and marriage, own retirement planning may often take a backseat to let other financial goals be on the forefront.
As such, the financial advisors may evaluate the risk profile of their clients and advise them on the mutual fund schemes, best suiting their risk profile so that the investors may have a smoother investing journey.