What is Risk Profiling, and How to Use it?
"Mutual funds are subject to market risk....". You would have come across this disclaimer said breathlessly in mutual fund advertisements. But, have you wondered, what are these risks, how do you measure them and how can you match them with your investments?
Here's all you need to know about risk profiling:
Your risk profile
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.
Your 'need' to take risks arises when you aim for higher returns to reach certain financial goals.
Similarly, your ability to take risks depends on your financial profile (like your remuneration, number of dependents and more) and the investment horizon.
Lastly, your willingness to take a certain amount of risk depends on how much risk you can psychologically handle.
A mutual fund distributor can choose various methods to evaluate your risk profile based on these.
The risk profile of mutual funds
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.
A riskometer defines the risk to the invested principal in a pictorial form. It is a 108-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
- Low to Moderate
- Moderately 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.
How to use risk profiling?
You can align your mutual fund risk profile for effective financial planning based on your own risk appetite. This can differ from one goal to another. For example, if your goal is to create an emergency corpus, you need higher liquidity and lower short-term
risk. Therefore, you can invest in a liquid fund.
On the other hand, if your goal is retirement planning, and you have ample years in hand, you can invest in a fund with moderately high risk or more if you are willing to do so.
Therefore, you can make your own risk-return combo by matching your own risk with that of a mutual fund. To understand this better, you can even seek financial advice from a registered investment advisor.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully