Money lesson plan: Before investing, this is what you must do

No two individuals are alike and so as investors. The way we as individuals evolve with diverse beliefs, our approach to value money also differs. What it means is that one’s risk appetite and tolerance level also differs from the people around. So, when it comes to managing money, doing a risk profiling plays an important role in determining how one save and grow their money. Let us understand.

What do you mean by risk profiling?
As an investor, every investment you make is directed towards achieving a particular financial goal. Risk profiling basically means a process to help figure out how much risk one can take versus how much risk should be taken for achieving financial goals. The reason why doing a risk profiling is very important is to help in planning investments prudently and deciding the right asset allocation. Depending on risk profiling, an investor can call themselves as aggressive, moderate or a conservative investor. A combination of two important parameters i.e. risk appetite and risk tolerance defines one’s risk profile. Let us understand both these terms in detail.

Risk appetite v/s risk tolerance:               
Many investors mistakenly assume these two terms are similar but it’s not true. The combination of these two terms defines your risk profiling, and both must be evaluated separately before one makes any investment decision. Risk appetite means readiness i.e. willingness to take any financial risk and whereas risk tolerance indicates one’s ability to take that risk. For example, you may love mountain trekking but you cannot take up the same unless you are physically fit to take on that kind of activity. Similarly, as an investor one can be a risk taker by nature and are very much open to investing money in any financial products with a higher return potential but carries a risk say market volatility. But, before investing money in that financial product, they need to first analyse financial standing which may or may not allow them to do that risky investment, otherwise.

Parameters to determine risk appetite:
Age: Typically risk appetite declines with age. Primarily, due to the fact that as an investor progresses in his or her life and say they are nearing their retirement age, then they cannot invest or bear the risk of losing their money as compared to a young investor who is in a much better shape to take greater risks.

Previous experiences: Risk appetite also depends on one’s past experiences in terms of investments in any financial product which have made them more comfortable with the overall risk and return pattern and tend to invest in them repeatedly.

Knowledge & information: A good knowledge about any financial products tends to give a higher risk appetite.

Parameters to determine risk tolerance level:
Income: Net income is one of the most important factors for defining risk tolerance. The higher one’s income, higher is the risk tolerance level which allows taking higher risks. It helps one to absorb any possible downfall in their portfolio.

Financial Obligations: Risk tolerance level depends on one’s dependents also. If an individual is the only breadwinner in his or her family and has dependents like children or parents to take care then until unless they plan for children’s education/marriage and parent’s medical emergency fund, maintenance etc., will not be able to take the risk to grow their wealth.

Expenses: One’s expenses also define the risk tolerance level. So, even if an individual has higher income but if their expenses are also high then the ability to take risk will be lower. It is important to keep a check on expenses and keep financial life healthy.

Timeline to achieve your goals: Investments should always be done to achieve financial goals within a certain timeline. So the moment an individual is near to meet the investment objectives, risk tolerance level goes down. Because it makes less tolerant to take a higher risk which otherwise can put money and goals in jeopardy.

So always remember to check your risk appetite and risk tolerance level before you set out to do your financial planning and invest in any financial product.

By Rishabh Parakh

(The writer is chartered accountant and chief gardener of Money Plant Consultancy)

Source: DNA Money