Why Risk profiling is important in financial planning?

What is risk profiling?

The goal of any investment is to achieve the best possible rate of return. However, every investment entails some level of risk. A reasonable investor will always expect a larger return when there is a higher risk. As a result, investors who are willing to take more risks can expect a bigger return. The goal of risk profiling/assessment is to figure out how much danger you're willing to take. This will assist the advisor in determining how you would react to various risk scenarios, and the evaluation will ultimately form the basis for investment recommendations.

Each person may have a different perspective on risk. Many factors influence how you perceive danger. Your ability to take risks and your willingness to take chances are the two most important factors.

What is your risk-taking capacity? An individual's risk-taking ability is defined by a combination of objective characteristics such as net worth, income level, time horizon, and liquidity requirements. A long-term aim, for example, allows you to take more risks, and vice versa. This is due to lower liquidity requirements and a greater likelihood of recovering losses over a longer period of time. Similarly, a person with a larger income or net worth may be more willing to take risks due to their ability to maintain a comfortable lifestyle in the event of an investment loss.

Your attitude toward risk determines your readiness to take chances. This aspect of risk evaluation is entirely subjective. Personality, background, financial knowledge, natural biases, and a variety of other factors all play a role. You are likely to score low on this area of your risk profiling if you dislike volatility in your investments and prefer stable performance. Similarly, an investor who seeks maximum profits and is willing to accept major risk in their investments will do well.

Your financial advisor's task is to balance the above two parts of your risk profile to comprehend your risk profile. There will be conflicts if an investor's capacity and willingness to take risks do not always match. Your financial advisor will assist you in determining where you stand and what these outcomes mean for you.

Risk Profile Assessment

Every investor's main motivation for investing is to achieve their financial objectives. Risk profiling enables you to determine how much risk you should accept in order to achieve your financial objectives versus how much risk you can handle. Your financial situation, or the balance between your responsibilities and assets, is a critical factor in determining your risk profile.

Professional financial planners utilize risk profiling to identify the best degree of investment risk for their clients. Risk profile aids in determining a client's needed amount of risk, risk capacity, and risk tolerance.

Risk Required

This refers to the amount of risk that must be taken on investments in order to attain the desired level of return. If you are not willing to accept that much risk, it will be tough to attain your objectives. This is because by taking on more risk, you increase your chances of receiving larger long-term profits.

Risk Capacity

This refers to the amount of financial risk or loss that a client is willing to accept in order to achieve their objectives. This is usually determined by their age, income, or length of service with the organisation.

Risk Tolerance

This is the amount of risk a client is willing to take in order to attain their objectives. It's a psychological indicator. It refers to a person's emotional comfort level with taking risks.

Things to keep in mind

Separately assess

Separately assess your risk tolerance, risk capability, and risk necessary. These are three distinct things, and a portfolio is built based on and influenced by all three elements. If you leave one unattended, the Risk Profile will become defective.

Do the comparison

Compare the results to see whether there are any disparities between the client's risk tolerance, risk capacity, and necessary risk. As we say, "we know something, but think something else, and then talk about something completely else." It's about striking a balance between thought and action.

Understand the risk-reward trade-offs

If an investor, for example, has a high risk tolerance but a limited risk capacity, he must determine the appropriate level of risk to fulfil his objectives.

Eliciting information

An advisor must be excellent at eliciting information from an investor about their goals, present and future income and costs, and current and anticipated assets and liabilities in order to calculate the risk required. More data equals a more accurate judgement.

Common mistakes that you should avoid

Relying solely on previous data rather than considering predicted future returns. History has passed us by, and circumstances have altered. Until mid-2016, no one had heard of demonetization. What happened in the past will not be repeated in the future.

Making insufficient provisions for life expectancy and health-care costs. Recently, I had an investor who insisted that I recalculate his cash flow in the event that he and his spouse live for 100 years instead of the 85 years that we usually calculate.

Failure to rebalance portfolios at regular intervals, resulting in the portfolio's risk/return drifting away from the appropriate risk/return. I'll say it again: asset allocation explains more than 90% of the variation in a portfolio's quarterly results.

Conclusion

The whole decision-making strategy and process will be influenced by an individual's risk profile. When it comes to evaluating correct asset allocation in an investment portfolio, a risk profile is crucial. You can avoid panicking later when a danger is realised by determining how comfortable you are with investment ups and downs. As a result, it's critical to invest according to your risk tolerance.