Your Money: Know how an investor’s risk profile is constructed

They have misinterpreted risks. In conditions where they are willing to take risks, they would not want to make immature decisions and lose money as a result.

By Rachit Chawla

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When you hear the word ‘risk’, you might sense opportunity or assume a potential threat of loss. It depends on the individual’s perception; risk means different to different people. In investment, risk profiling means a practice to identify someone’s preparedness to take risks. Different situations are taken into account, including the acceptability as well as the understanding of the risk factor.

Majorly considered related to the investment, risk profiling is the result of how you prepare for and react to adverse situations in life. The score is derived after calculating the investment objective, investment horizon, and psychological factors. In investment, risk profile is based on these three factors: Perception of risk, emotional tolerance, and financial capacity.

When you are considering investing, you should close work around the risk profile questionnaire. It not only calculates the risk constructs but also shoots up a follow-up question that helps comprehend the investor’s perspective in all of the three risk factors in investment. It is highly crucial to have an in-depth understanding of these factors to be aware of the consequences of taking risks. It helps in finding a sweet spot in risk-taking.

Since different people have different objectives, goals, and rationales behind the investment, their appetite to take risks differs. Before investment, a financial planner should talk to the investor in detail, and they should work out a sweet spot. As the market is volatile, the financial planning must be robust. These risk factors, which are known to be the core of every financial planning, can mitigate any risk.

Emotional tolerance
How you feel about a specific financial planning event in your history of investing is what emotional tolerance is about. How do you tend to react when there is a 20% downturn? How do you react when there is a 10% increase? These are the questions an investor must ponder before investing in the volatile markets.

Anyone’s financial situation and place to add or reduce volatility are measured by the financial capacity to take risks. But it definitely doesn’t mean that it also measures someone’s capacity to take calculated risks in order to meet certain objectives of their financial planning. That process is different and also includes mathematical equations. However, the results often alter the capacity to take risks. For example, if a person has the capacity to keep up with her cash inflow without touching her investments, they fall in the “high capacity to take risks”. The same way, if the investments get threatened, and there’s an urgent need to start producing income, then the person has a low capacity to take risks.

Perception of risk
The assumptions people have about taking financial risks are majorly influenced by their financial personalities resulting in conflicts with reality. They tend to presume the situation of the markets as being risky, but their assumptions can be pretty varied from reality. For instance, if someone manages to take risks in life, they might think about the market crashing, or political disruption or even about the federal bank acting in a certain way, they might make decisions they generally won’t make if they based it on their financial capacity or even emotional tolerance.

They have misinterpreted risks. In conditions where they are willing to take risks, they would not want to make immature decisions and lose money as a result.

The writer is CEO & founder, Finway FSC