A risk profile is an evaluation of an individual’s willingness and ability to take risks. It helps during financial planning process to assess whether there is need to take risks or not.
A risk profile is important for determining a proper investment asset allocation for a portfolio.
Risk profiles are generally assessed in 5 categories through various types of questionnaire tools.
- Low
- Moderately low
- Moderate
- Moderately high
- High
Risk can be thought of as the trade-off between risk and return, which is to say the trade-off between earning a higher return or having a lower chance of losing money in a portfolio.
Willingness to take on risk refers to an individual’s risk aversion. If an individual expresses a strong desire not to see the value of the account decline and is willing to forgo potential capital appreciation to achieve this, this person would have a low willingness to take on risk and is risk-averse.
Conversely, if an individual expresses a desire for the highest possible return—and is willing to endure large swings in the value of the account to achieve it—this person would have a high willingness to take on risk and is a risk seeker.
The ability to take risks is evaluated through a review of an individual’s assets and liabilities. An individual with many assets and few liabilities has a high ability to take on risk. Conversely, an individual with few assets and high liabilities has a low ability to take on risk. For example, an individual with a well-funded retirement account, sufficient emergency savings and insurance coverage, and additional savings and investments (with no mortgage or personal loans) likely has a high ability to take on risk.
Willingness and ability to take risk may not always match up. For example, the individual in the example above with high assets and low liabilities may have a high ability to take on risk but may also be conservative by nature and express a low willingness to take on risk. In this case, the willingness and ability to take risk differ and will affect the ultimate portfolio construction process.
It is crucial to ascertain when and how much risk is appropriate and when it’s not.
Before putting money in an investment, you should consider your ability to recover from a financial loss; both – financially and emotionally.
In addition to the level of risk and potential return any investment product carries, how quickly you can get your money when you need to encash your investment.
General recommendations are to not risk emergency funds or savings for shorter-term goals. Simply because you could end up with less money.
There, of course, are exceptions. Under the conducive situations, taking on some risk when investing for a specific short-term goal or even investing some of your emergency funds could be right for you.
To decide the level of risk you can take; you should first assess your financial health.
‘Risk’ does not simply indicate potential loss of money in an investment but also means missing out on potential gains if you did not invest.
All investments involve some degree of risk in some form even those appearing safe. Some of them are Inflation risk, Liquidity risk, Interest rate risk, Market risk, Currency risk, Default risk, Sector risk, etc.
Each has its own level of risk/return ratio. Within each category, specific products may carry more risk or provide more gain than others.
- Savings bank accounts
- Government securities
- Bank Deposits
- Debentures
- Commodities
- Corporate Bonds
- Equities
- Mutual Funds/Index Funds/Exchange-traded funds (ETFs)
- Annuities/Whole Life Products/ ULIPs/ Endowment policies. etc. etc.
There are also many alternative investments (i.e., real estate, P2P lending, precious metals, artwork, cryptocurrency, etc.) you might consider when deciding where to invest your money.
Educate yourself before investing your hard-earned money in something you don’t understand.