What is Risk profiling and its Importance in mutual fund investing
We have all read the disclaimer: "Mutual fund investments are subject to market risks; read all scheme-related documents carefully before investing". It tells us that all mutual fund investments are subject to risk, although the degree of risk may vary. Before investing in any mutual fund scheme, an investor needs to assess whether the risk involved suits their profile. They need to do their risk profiling and match it with the risk involved in the mutual fund scheme. This article discusses risk profiling and its importance in mutual fund investing.
Before we discuss all about risk profile, let us understand Mutual Fund Riskometer.
Mutual fund risk-o-meter
Every fund house displays a risk-o-meter on every mutual fund scheme page, which shows the degree of risk involved in investing in that scheme. The risk-o-meter looks something like this.
The above image shows the risk-o-meter arrow pointing towards "high". It means out of the six levels of risks as defined by SEBI, the current scheme is suited for investors with a high-risk profile. Similarly, the fund house has to display the risk-o-meter for every mutual fund scheme.
Purpose of risk-o-meter
The risk-o-meter tells an investor the degree of risk involved in investing in that particular mutual fund scheme. The investor needs to assess their own risk profile, evaluate whether the scheme suits their risk profile, and decide whether they should invest in the scheme.
So, that brings us to the next set of questions: What is risk profiling, and what is its importance? Let us explore the answer to these questions.
What is risk profiling?
Risk in general means deviation from the expected outcome. Most mutual fund investors correlate risk to lower than expected returns or losses. Risk profiling is the process of assessing how much risk an investor can take or tolerate. Based on the capacity of risk that an investor can take or tolerate, the investor can be categorised into the following:
|Conservative||An investor with a conservative risk profile is intolerant to any risk. They are more focused on protecting their capital rather than generating returns. They have to be content with low returns. Conservative investors can invest in debt mutual funds with the objective of protecting capital. They are averse to any exposure to equities.|
|Moderately conservative||An investor with a moderately conservative risk profile can take a low risk. Their major exposure is to fixed-income securities with a small equity exposure. They can expect low to moderate returns on their investments.|
|Moderate||An investor with a moderate risk profile can take a balanced exposure to equity and debt. The equity exposure can be 40 to 60%, and the balance can be debt exposure. They can expect moderate returns on their investments.|
|Moderately aggressive||An investor with a moderately aggressive risk profile can take high risks. Their major exposure is to equities with a small debt exposure. They expect high returns on their investments to compensate them for the high risk that they are taking.|
|Aggressive||An investor with an aggressive risk profile can take the highest degree of risk. Their entire exposure is to equities. They expect high returns on their investments to compensate them for the high risk that they are taking.|
Importance of risk profiling
Risk profiling helps investors decide the degree of risk they can take and accordingly invest in those mutual fund schemes that match their risk profile.
On one side, we have a mutual fund scheme with the degree of risk involved (risk-o-meter). On the other side, we have individuals with the degree of risk they can take (risk profile). Risk profiling plays an important role in helping investors match their risk profile with the degree of risk that mutual fund schemes carry.
Selection of mutual fund schemes for investment
In the above section, we understood how risk profiling helps investors in matching their risk profile with the degree of risk involved in the mutual fund scheme that they are investing in. The following are some examples of individual risk profiles and the types of mutual fund schemes that they can invest in based on the degree of risk involved.
|Individual risk profile||Mutual fund scheme||Risk-o-meter|
|Moderately conservative||Liquid fund||Low to moderate|
|Moderate||Debt hybrid fund||Moderate|
|Moderately aggressive||Equity hybrid fund||High|
|Aggressive||Sectoral fund||Very high|
Note: The above is just an example to explain how risk profiling helps an individual choose mutual fund schemes based on the degree of risk involved. It may not suit everybody’s risk profile. To do your risk profiling and accordingly select mutual fund schemes for investment, you may take the risk assessment questionnaire on the GlideInvest app or website.
Factors that influence an individual’s risk profile
Many factors influence an individual's risk profile. Some of these include:
Age - An individual's age is one of the biggest factors that influence an individual's risk profile. A young individual has a long investment time horizon to achieve financial goals like retirement. An unmarried individual without any home loan or other loans can afford to take high risks. As an individual's age increases, the risk appetite diminishes.
So, to start with, a young individual in the 25 to 35 years age bracket will have an aggressive risk profile. The risk profile will become moderate at the 35 to 45 years age bracket. The risk profile will become moderately conservative as age progresses to the 45 to 55 years bracket. And finally, just before retirement and during retirement years, the risk profile will become conservative.
Life events and financial liabilities - The risk appetite diminishes as an individual crosses certain life events and takes up financial liabilities. The life events include getting married, having kids, taking responsibility for financially dependent parents, etc.
The financial liabilities include home loans, education loans, vehicle loans, and other types of loans. Along with reducing the risk appetite, loan EMIs also reduce the disposable income available for investment.
Dependent family members - As the dependent family members increase, they influence the risk profile on the downside. For example, if the spouse is a housewife or a househusband, the responsibility of running the family is on one spouse, reducing their risk appetite. On the other hand, if both the spouses are working, it increases their risk appetite.
Financially dependent retired parents reduce an individual's risk appetite.
Profession - If an individual is salaried, working in a company (for example, IT) that is doing well in a sunrise industry; the career prospects are bright. It increases the individual's risk appetite. Similarly, if an individual is working in an industry (for example, airlines) that is not stable (where job losses, salary delays, salary cuts happen sometimes), it reduces their risk appetite.
If an individual is in a business that faces regular ups and downs every couple of years, it reduces the risk-taking ability.
Financial back-up - If an individual is disciplined to save a certain percentage of their income every month and has built a financial buffer, the risk-taking ability increases. Similarly, if an individual lives in a hand-to-mouth situation, the risk-taking ability is low.
- Human psychology - If an individual's conditioning is such that they splurge money on things they don't need, they are barely left with any resources for saving and investing. Some individuals try to imitate their peers on lifestyle. They also are not left with enough savings to invest. Such individuals have a low-risk appetite.
Choose your investments as per your risk profile
In the above sections, we have understood how to assess one's risk profile and choose mutual fund schemes with the appropriate degree of risk. An individual needs to take only that much risk that they can tolerate. The strategy helps an individual sleep peacefully even when the investments are not doing as expected in the short term.
Investing in mutual funds with the Glide Invest App
Now you understand how to match your risk appetite with the degree of risk that mutual funds carry. You can partner with the Glide Invest App for your financial planning journey to get recommendations for the appropriate mutual fund schemes based on your risk profile. You will get advice on planning and systematically investing towards your financial goals.
With Glide Invest, you will get guidance for:
- A personalised risk profile assessment
- Identifying your financial goals
- Appropriate asset allocation
- Making a financial plan for each goal
- Automating the financial plan
- Review and analysis of your financial plan
- Hand holding you till your financial goals are achieved