Risk management is not limited to avoiding high-risk investments. You can take various steps like hedging, diversification, and asset allocation. But, first, you need to perform a risk profile assessment and understand the risk criteria you should build your portfolio around.
This blog covers what a risk profile is, how you can reduce risk in a portfolio, and risk profile-based asset allocation.
What is a Risk Profile?
The risk profile is an evaluation of their willingness and ability to take risks. Knowing your risk profile is essential to determine the asset allocation that suits you. Typically, investors fit in the following categories of risk profiles:
- Aggressive Risk Profile
- Moderately Aggressive Risk Profile
- Moderate Risk Profile
- Moderately Conservative Risk Profile
- Conservative Risk Profile
Conservative investors are risk-averse individuals who prefer stable income rather than growth investments that tend to be riskier. On the other end of the spectrum, we have aggressive investors willing and able to take the risk involved with high growth investments.
Balanced investors who would fit in with the moderate risk profile prefer equal exposure to high growth investments and stable investments.
An investor’s risk profile depends on psychological factors, capacity to take losses, age, income, and expenses, among other factors. You can find various online risk profiling tools and risk profile calculators. These tools typically require investors to fill out a risk profile questionnaire.
NOTE: An investor’s risk profile can change with time and age or events like job loss, promotions, and family-related events like marriage and birth of a child.
How can you reduce the risk in your portfolio?
Investment risk is the chance of an asset underperforming or making losses. This is the chance of a particular stock or bond underperforming or making losses. When we talk about risk in your portfolio, we mean the chance of the portfolio as a whole failing to meet your financial objectives.
There are 2 approaches to reducing the risk in your portfolio. Firstly, you could address the investment risk in each asset and hedge against those risks. Secondly, you could build your portfolio with an asset mix that suits your risk profile.
Asset allocation based on the risk profile
Asset allocation spreads your funds across various asset classes like stocks, bonds, real estate and commodities. Every asset has its own risk-to-reward ratio. The goal is to create a portfolio that gives the desired risk-to-reward ratio by spreading the funds across asset classes.
Risk profile based asset allocation involves the following steps:
- Identify your own risk profile
- Identify the risks of each asset class (stocks, bonds, real estate and commodities)
- Rank the asset classes by their risk factor
- Build a portfolio with the overall risk that suits you
Suppose you make a portfolio with risk profile based asset allocation for a moderate risk profile. Then would have a portfolio with similar amounts of high-risk investments with high return expectations and low-risk investments with stable return expectations.
Similarly, suppose you are building a portfolio with risk profile based asset allocation for an aggressive risk profile. Then you would have a high percentage of high-risk investments with high return expectations and a low percentage of low-risk investments with stable return expectations.
Building a portfolio based on your risk profile is a good way to manage risk. Every asset will have its own risk-to-return ratio, and you might not find an asset that suits your risk profile at all times. But, you can attempt to build a portfolio with a risk-to-return ratio that suits you through risk profile based asset allocation.
At WealthDesk, you can find curated portfolios called WealthBaskets. You can find WealthBaskets with low, moderate and high levels of risk. These WealthBaskets are managed by SEBI registered professionals who take care of curation and rebalancing.
A person’s risk profile depends on their willingness and ability to take risks. It depends on psychological factors as well as your financial situation.
Asset allocation strategies can be broadly classified into 3 types:
– Strategic Asset Allocation
– Tactical Asset Allocation
– Dynamic Asset Allocation
Some investors may feel that they can take only a finite amount of risk. So, they may do risk budgeting in asset allocation to limit the overall risk.
Risk tolerance is the amount of risk an investor is willing to take. Often we hear that young people have a higher risk tolerance than older people. But, age is not the only factor determining risk tolerance. Other factors like income, wealth and psychological characteristics also affect risk tolerance.