How does determining your investment objective indicate your risk profile?

All investments carry with them a disclaimer that states that returns are subject to market risks. Investing in the market carries with it a certain element of risk, and you must understand these risks before you make any financial decision. While it is important to make investments to fulfil your financial goals, it is crucial that  you understand the risks to avoid any mistakes that may set you back. Your risk profile indicates the kind of investment vehicle you should choose, and your investment objective determines your risk tolerance.

Let us first understand what a risk profile is, followed by how your investment objective can determine the risk profile you’re a part of.

What is a risk profile?

A risk profile can be defined as your willingness or tolerance toward taking risks. Creating a risk profile is an imperative process towards determining the right investment asset allocation in your investment portfolio. It enables you to identify the acceptable amount of risk that you can endure. In this particular case, risk refers to your tolerance to market fluctuations and volatility.

If you’re looking for your principal investment amount to not decline, and are willing to let go of potential capital appreciation in this process, you have a low willingness to take on market risks, and hence have low risk tolerance. On the other hand, if you desire to make the highest possible earnings from capital appreciation, and are willing to take the chance that your principal investment amount may decline if a particular investment may not pan out, you have high risk tolerance.

Your ability to take risks is determined by reviewing your liabilities and assets. If you have more assets than liabilities, you can take more risk, and vice versa. However, your will to take on risks and your ability to sustain them might not always match up. For example, you may have a lot of assets, but are of a conservative nature, and showcase a low desire to take on risks. In this case, the ability and the willingness to take risks are different, which affects the portfolio construction procedure.

Now that we have a fair idea of what a risk profile is, let us understand the factors that determine your risk appetite.

Factors that dictate your risk appetite

Prior Experience: Just like you become better at a sport, or any other task with practice and experience, you gain more experience as you continue investing in the market. Your knowledge of investment products, market trends, your last portfolio, and its performance are all key factors that  are included in your past experience. These experiences make you a veteran investor and can impact your risk appetite.

Present Scenario: Your present age, financial liabilities, income sources, and engagement levels are key determinants of your risk tolerance. If you’re a young investor with no financial liabilities, you can have high risk tolerance. On the other hand, if you are a middle-aged man with a family, you’re unlikely to take heavy risks with hopes of high returns.

Investment objectives: The most important factor that determines your risk appetite is the reason why you started your investment journey and why you’re continuing the same.

How does determining your investment objective indicate your risk profile?

You can begin investing for a plethora of reasons, and every reason has a different mode of investment suitable for fulfilling the objective. From wanting to go on an international vacation, to buying a car, to a retirement plan, everything can be a reason to start investing. Depending on your investment objective, your risk profile can be indicated.

For instance, if you’re starting your investment journey to create a stable retirement plan, it is unlikely that you will undertake huge risks and be an aggressive investor. In this case, you would rather invest in funds that provide consistent market returns despite any fluctuations.

What are the types of risk profiles?

There are three broad brackets in which risk profiles can be categorised into. Based on this categorization, you can identify which profile you come under.

Conservative: A conservative risk profile indicates an investor with a low risk tolerance. If you’re a conservative investor, you will be inclined towards investment methods that are safe and protect your principal corpus. Returns on investments are secondary as long as your investments do not depreciate.

Moderate: If you’re a moderate risk taker, you tend to strike a balance between risk and reward. You would opt for a high returns scheme on an acceptable risk level, but you’d probably skip anything with extremely high risk elements.  

Aggressive: This particular risk profile showcases the most willingness towards withstanding market fluctuations, aiming at high returns on their investments. Usually, this profile constitutes veteran investors who are well versed with the market and investing intricacies. Moreover, these investors also have long-term plans, which is why they are okay with absorbing any short-term market fluctuations.

All being said, fixing your investment objective can help you analyse your risk profile better, and no matter what risk profile you consider yourself to be, you should always consult your financial advisor before making any financial decisions.