Importance of Assessing the Risk Appetite (Risk Tolerance) prior to making an Investment Decision

Risk Appetite Importance

With Indian Equity Markets creating fresh record highs in the recent past, many new individuals wish to invest in markets, many forums are flooded with questions on what is the right time to invest in Indian Stock Markets, what is the correct amount to start investing with? etc.

Firstly, the answers to the above mentioned questions are subject to change from person to person just as the risk taking capacity. However, before making an investment decision in stock markets, it is advisable for a prospective investor to go through the assessment process of his/her risk taking capacity, link it with the financial goals that he/she may wish to achieve at a later date in life.

The question is :

Why is Assessment of Risk Appetite (Risk Tolerance) of a prospective individual so important?

Well, the answer is discussed in detail below:

A risk assessment process of an Individual investor is the process wherein the current Financial status of the individual alongwith his family members, his financial goals at a later date in life (in the Zero-Salary Age), his current source of income, number of dependents, the amount of savings he can manage per month, his expected rate or return, emergency etc is assessed, by the financial advisor.

In simple terms, the Financial Advisor here, becomes the doctor and the Prospective Investor becomes the patient. So before prescribing variety of medicines, a financial advisor needs to assess the disease that the prospective investor is suffering from and then accordingly need to prescribe the medicine, so that the medicine doesnot create any side effects and the disease gets cured with the medicines that are suitable to the patient.

For such a risk appetite assessment, a financial advisor prepares a brief questionnaire in which the prospective investor needs to answer in a yes or no or tick options and at the most answer in short.

The indicative contents of a risk profiling questionnaire may be considerd as mentioned below:

  • Name

  • Age

  • Type of Family: Nuclear/Joint Family

  • Number of Family Members:

  • Earning members of the family:

  • Number of Children:

  • Dependent Members:

  • Source of Income:

  • Monthly Income:

  • Monthly Savings amount:

  • Do you have a bank account?:

  • Do you have a PAN Number?:

  • Do you invest your Savings?:

  • Where do you invest your savings?:

  • What are your future financial goals?:

  • Do you have seperate reserves for emergencies?:

  • Do you hold an insurance policy?:

  • Do you have a mediclaim policy?:

  • Do you invest in Mutual Funds?:

  • What will be your reaction if say your investment of ₹100 turns out to be ₹0 some day? Will you still stay invested?

  • What is your expected return for your investments?

    Based on the client’s answers to the above questions, a financial advisor will be able to analyze the risk profile of an investor and decide on the category of investors the client belongs to.

    Briefly following are the indicative categories of risk appetite of the clients based on the time horizon and the return expected by him/her.

    1. Risk Averse: An investor who is not willing to take any risk, safeguarding the investments is the sole objective for him along with peace of mind. Such an investor is ready to forgo the higher returns that he might get if he takes a little risk.

    2. Conservative: Such an Investor, is conservative in his approach, meaning he is ready to take marginal risk than the risk averse investor to earn a higher rate of return than the traditional investment avenues offer but still is not a high risk taker, that is why he falls into the Conservative Category. For an investor in Conservative Category also, the capital protection will be a priority and hence he might have knowledge about the markets but will not take chances when it comes to the capital protection.

    3. Moderate/Balanced: A moderate or balanced investor is the one who understands the market mechanism, can take risk as he doesn’t wish to see his capital getting eroded with inflation and tax. He can take risk in the short term with an aim to achieve the desired growth in the longer term.

    4. Growth: A growth investor is the one who eyes growth in his investments in the long term. Such an investor is ready to take risks for long term growth, known to the various investment mechanism and is ready to take risk if he sees optimum growth opportunity ahead.

    5. High Growth/Aggressive: A High growth/Aggressive investor is the one for whom capital appreciation in the long term is the only goal. Such investor is ready to forgo the capital invested in short term if he sees opportunity of tremendous growth in the long term. If required, such an investor can also take contrarian positions to achieve the goal of Maximum returns, as he also possess knowledge about the Investment mechanisms and asset allocation strategies and has the skills to play with it.

      Based on the risk profiling of an investor, the financial advisor makes asset allocation for investments from the amount that the investor wishes to invest. Following are the indicative asset allocation strategies for various risk profiles of investors:

      FDs/Cash/Savings Stock Markets/Growth Assets

      Risk Averse 100% 0%

      Conservative upto 60% upto 40%

      Balanced upto 50% upto 50%

      Growth upto 20% upto 80%

      Aggressive 0% upto 100%

      Thus, risk profiling helps an investor and a financial advisor as well to check for the risk tolerance capacity of an investor, based on which the investment plan linked to his financial goals can be made with appropriate asset allocation so that he can comfortably build wealth and achieve his/her financial goals.

      Conclusion:

      While making an Investment decision across asset classes or in stock markets, the first and most important step is to check the risk tolerance analysis and the financial goals of an investor and then make an informed decision on making an investment suitable to an investor and his personality.

Please wait...

Join the Informed Investors Community

Investing without research is like playing poker, without looking at the cards.