Risk Profiling of Investor Vs. Risk of Mutual Fund Scheme

The number of unique mutual fund investors is up from 37.9 million (April 2023) to 45.2 million (April 2024), an increase of 19.3 per cent, according to the Association of Mutual Funds in India (Amfi) data. A poor experience early in their investment journey could turn many of these newcomers off equities for a long time, which is why they must enter the market cautiously.  

One can understand the risk profile as the quantification of risk tolerance of an individual.

Every individual investor is unique. Not only with regards to investment objectives but even in approach and view of risk. This is what makes Risk Profiling absolutely crucial before investing.

 A Risk Profiler is essentially a questionnaire that seeks an investor’s answers to questions about both “ability” and “willingness”. It is highly recommended that investors contact their Mutual Fund distributor or an investment advisor to complete this task and get to know their Risk Profile.

Every individual has a different tolerance to market Volatitilty, the gauge of how fast the value of securities or market indexes moves up/down or risk based on several factors like disposable income, age, et al. Therefore, risk profiling helps both an investor and financial advisor to create a specific investment portfolio with an asset mix correlating to his risk profile.

Organisations also use the term ‘risk profile’ to define the potential threats to which it is exposed.  In the AML/CFT universe the firms undertake such analysis regularly. By identifying the risk profile, organisations can take corrective or pre-emptive measures to minimise, and sometimes, even avert impending losses. However, the term’s predominant use is found in the context of an individual’s risk tolerance.

Risk tolerance, on the other hand, refers to an investor’s willingness to take risks or the level of volatility in returns one is ready to deal with.

Investor’s risk  is profiled keeping in mind multiple factors such as your habits, behaviours, family orientation, attitude towards risk, age etc. Risk appetite refers to the amount of risk you have the capacity to absorb, and this broadly helps determine the asset classes (equity, debt, gold, etc.) and style of investment that you are comfortable with (growth, value, etc.).

Investor’s risk profile

Your risk profile is broadly a factor of:

1. Your risk capacity,

 

2. Your risk tolerance and

 

3. The risk you need to take to achieve your planned financial goals.

 

Your risk capacity or in other words your ability to take risks depends on factors that can be quantified (your age, income, number of dependants, etc.).

Risk tolerance or your willingness to take risk indicates your emotional tolerance towards the ups and downs in the market and towards risk taking in general. This is essentially a psychological characteristic.

Required risk, is a mathematical calculation under a set of assumptions that helps you understand the level of risk you will need to take, to achieve your financial goals. Some experts may consider required risk to be a part of an individual’s risk capacity, which is essentially a financial characteristic.

Every investor has a unique perception of risk. Therefore, measuring the risk appetite of an investor is vital for risk profilers. They do this to ensure that you are not sold a riskier mutual fund than you can handle. To measure your risk appetite, risk profilers evaluate your Need, Ability, and Willingness to take a risk.

Investor’s 'need' to take risks arises when you aim for higher returns to reach certain financial goals.

Similarly, the ability to take risks depends on one’s financial profile (like your remuneration, number of dependents and more) and the investment horizon.

Lastly, the willingness to take a certain amount of risk depends on how much risk you can psychologically handle.

Investors often vet their financial standing, i.e. balance between assets and liabilities, to evaluate the level of risk they can take.

Financial advisors also utilise the asset-liability balance of an investor as a towering factor of risk profile determination.

For instance, an individual who has several assets at his/her disposal in comparison with very few liabilities will likely be a risk-seeker.

An individual with sufficient retirement capital, emergency funds, and no loans will be in that category.

Since such investors’ financial standing would not suffer greatly due to short-term market volatilities, they can afford to look at the bigger picture of exponential returns at that cost.

However, an individual whose asset value is not all that substantial, but his/her liabilities count is significant will most likely be risk-averse.

This category of investors possess limited adjustment space  in their budget for accommodating loss from short-term volatilities and will be definitely more inclined to look for a safe investment haven.

One should note in this context that a healthy share of assets and fewer liabilities does not always prompt an individual to undertake a risky investment approach. It strictly depends on an individual’s own psychology of risk in that case.

Major Factors influencing an Investor's  Risk Profile

 

Here are a few factors other than the asset-liability screen that have a bearing on risk profile:

1. Age

A young investor with minimal responsibilities can think of putting more money into riskier investments. A family-man may need a different approach, and someone nearing retirement may best approach investing conservatively.

2. Income

If you have a regular, stable income to support your lifestyle and your future prospects are bright, you can consider taking a higher risk when investing to earn higher returns.

3. Investment Horizon

If your financial goal is far out, you can afford to take risks now as you have the opportunity to ride out short-term fluctuations in the market by staying invested for a longer duration.

4. Emergency Fund

It is recommended to have at least 6-8 months of expenses, including EMI, for contingencies. Having a sufficient corpus will allow you to take more risks in investing.

5. Insurance

It is mandatory to have adequate life insurance before you start taking risks with your money. A health cover helps avoid dipping into your savings in cases of medical emergencies.

6. Family Wealth

Surplus money that you can put to good use and earn more can be invested in riskier instruments. However, if a loss of that wealth will stretch your finances, it is better to invest conservatively.

7. Experience

Investors who have made successful investments are generally comfortable taking higher risks than someone who has made losses, or is a beginner.

8. Knowledge

This is the best investment one can make. Your understanding of a financial product and how the markets work determines your willingness to take risks. The higher your knowledge, the higher can be your risk appetite and vice-versa.

 Difference between Savings& Investments

The biggest difference between saving and investing is the level of risk taken. Saving typically results in you earning a lower return but with virtually no risk. In contrast, investing allows you the opportunity to earn a higher return, but you take on the risk of loss in order to do so.

Though both are strategies to create wealth ,here are the key differences between the two — and why you need both of these strategies to help build long-term wealth.

Deferring consumption is common feature in both strategies. Investment starts where you have covered your living expenses, with or without provision for emergency funds. Investing is money that you’re planning to leave alone to allow it to grow for your dreams and your future.

A savings account or bank fixed deposits are some of the popular savings options in India. It is similar to holding cash. You Only Live Once (YOLO) trend leaves people in financial problems in future.

Saving is merely the difference between income and expense. While investing is allocating part of the savings towards assets to create long term wealth. It would help if you strategically coupled your savings with investments to be able to generate significant returns.

The table below gives a comparison between Savings & Investment

Particulars	Savings	Investments
Purpose	Meeting Emergencies	Earn Return on money invested
Time horizon	Short	Long Term
Difficulty	Easy to deal with like SB account	Hard- Stricter procedures , disclosures
Risk	Bank account – Risk covered by Deposit Insurance and Credit Guarantee Corporation (DICGC) upto Rs 5 lakhs	Risk varies from less risky Govt Bonds to high risk Equity. Risk management tools are available ; but no guaranteed returns or even principal amount.
Protection against inflation	NO	Potentially over long term, guard against inflation
Liquidity	Very high	Not very liquid
Expenses	Not really matters	Fees , Taxes are accompanied in varying measures

Needs, Wants and Savings

 

Two key takeaways here that gain prominence when it comes to investing:

1. When what you can afford is more than what you want, listen to your wants, and
2. When your wants are more than what you can afford, go with what you can afford.

Certain questions you can ask yourself to figure out where you stand on the risk-o-meter.

1. For how long are you planning to invest?
2. How do you foresee your income in the future?
3. How many years do you have until retirement?
4. Do you own the house you live in?
5. Is your emergency fund full?
6. Are you comfortable with stable investments, or do you seek potentially high returns?

Example of Risk Profiler Tools

1.      Risk profiler tool by Mirae AMC

2.      Risk Profiler tool by ICICI AMC

The risk profile of Mutual Fund Schemes

Now that your risk profile is evaluated, it can be matched with that of the mutual fund you wish to invest in.

The risk profile of a scheme is the degree of risk attached to the principal invested. For this, you can refer to the risk profile disclosure on the first page of a mutual fund's scheme information document (SID). To better understand, you can also refer to the pictorial representation of your fund's risk profile in the riskometer.

Riskometer

A riskometer defines the risk to the invested principal in a pictorial form. It is a 180-degree line with an arrow pointing at a particular risk category or level. The risk levels mentioned on the riskometer starting from its left to the right side are as follows:

• Low
• Low to Moderate
• Moderate
• Moderately high
• High
• Very High

Looking at these categories, you can understand the risk to your principal.

Examples of mutual fund types and risk

• Looking at the lower risk level, there can be non-equity based mutual funds, particularly those offering higher liquidity—for example, liquid mutual funds and overnight funds.
• Then, there are funds with moderately low risk. These schemes can invest in debt, fixed-income and certain equity-based securities—for example, fixed maturity plans, debt-oriented schemes involving capital protection and certain arbitrage funds
• Going one level ahead to the moderate risk category, conservative monthly income plans and income funds are examples of the moderate risk category
• Next, there is the moderately high-risk category. Index funds, ETFs (Exchange Traded Funds) and solution-oriented funds are examples of funds that come under the moderately high-risk level.
• Sectoral or thematic funds are examples of high-risk funds.

Many are investing only in mid and smallcap funds, without realising that returns tend to be cyclical. If these funds do not do well in the near future, they might get disillusioned and quit

Concentration risk both on the Liability & Asset sides is displayed on AMFI site . This is a moving target and normally found disclosed at the respective fund’s website

Happy Investing