Do you know which category of Mutual Fund is the most suitable for your risk profile? To understand this, it is necessary to understand risk profiling. Because a mistake in risk profiling can lead to a bad outcome.
‘Mutual funds are subject to market risks, but are you aware of these market risks?
The risk profile of an investor influences many things like age, income, existing financial commitments etc.
An investor can choose an investment instrument according to his risk profile category
Do you know that the risk profile of an investor varies depending on many factors? Now you might be aware of this disclaimer: ‘Mutual funds are subject to market risks,’ but are you aware of these market risks that could harm your investments? As a result your financial goals too? Do you know which category of Mutual Fund is the most suitable for your risk profile? To know the answer, it is important to understand what risk profiling is and what kind of risk is there in your mutual fund investments which should help you find out how much investment risk you should take.
What is risk profiling?
Risk profiling is the knowledge of your risk-taking ability to find out how much investment risk you need to take to meet your financial goals on time. The risk profile of an investor is influenced by many factors such as age, income, current financial commitments, and debt position, target size, time on hand to meet the target, the need for money, etc. Now if you are thinking of investing in a mutual fund scheme, then understanding your risk profile can also help you in choosing the right category funds for you.
A mistake in risk profiling can lead to bad results. For example, suppose an investor wants to meet a target for which he needs a large amount in 1 year. As time goes on, it would be better to invest through low-risk investment tools such as fixed deposits or liquid mutual funds. Investing through a high-risk investment tool such as equity, short-term volatility can hamper the achievement of goals.
The risk profile of investors is usually categorized into five levels
- ‘Conservative’ for low-risk profile – ‘Moderately Conservative’ for medium-low-risky profile
- Moderate for Medium-Risky Profile
- Moderately aggressive for medium-high-risk profiles
- Aggressive for more-risky profiles
- An investor can choose an investment instrument according to his risk profile category.
Risk profiling process
There are three steps of risk profiling – knowing your risk capacity, estimating the risk required to meet your goal, and knowing your risk tolerance.
Risk capacitance shows the maximum amount of risk an investor can take to reach a particular return level so that the target is met within the anticipated time frame. The risk requirement is the level of risk taken to meet the goal.
Depending on the risk requirement level, suitable investment products can be selected to meet the target. The risk requirement may vary depending on the age of the investor, the size of the financial goal, the size of the investment, etc.
Risk tolerance is the level of risk that a person is willing to take while investing. This is taken into account by taking into consideration the current debt level of the investor, current financial commitments, insurance coverage, etc. Risk tolerance reveals price fluctuations and the level of volatility that an investor is prepared to raise to meet the target. In this way, an investor can make an investment plan to meet his / her goals when they are aware of their risk capacity, risk requirement, and risk tolerance. Basically, a registered investment advisor has to follow certain guidelines set by the Securities Exchange Board of India (SEBI) and the Association of Mutual Funds in India (AMFI) to evaluate the risk profile of the investor.
These Risk to know when investing in an MF scheme
Each mutual fund category has different types of risk. For example, the risk associated with debt funds is different from the risk associated with equity funds. In addition, different types of schemes may have different types of risk in the same mutual fund category. For example, the risk of short-term debt funds may be different from long-term debt funds. In small-cap equity funds, there is more market risk than long-term equity funds. Interest rate risk, credit risk, liquidity risk, inflation risk, price fluctuation risk, concentration risk, etc. are some of the common risks associated with mutual funds investment.
You cannot eliminate the risk, but adopting the right strategy and making smart choices of mutual funds can help reduce the risk to a great extent.