Why do we build portfolios with different risk levels for different clients: here’s the science behind it
Risk profiling is an important process that evaluates how much investment risk you should take. It might not seem important when the investments are doing well. But when the markets fall, investing in line with your risk profile helps ensure that you don’t lose sleep or panic and sell before a market recovery.
There are two important aspects to determining what your risk level should be- risk tolerance and risk capacity. Risk tolerance is a measurement of your attitude towards risk i.e. the willingness to accept potential investment loss. If you are not very comfortable with market volatility and uncertainty, it means that you have a lower risk tolerance. Risk tolerance does not vary much over time, as the inherent nature of a person stays more or less constant.
Risk capacity, on the other hand, is an estimate of whether your circumstances would let you take investment risks. This depends on factors such as age, financial situation and the number of people dependent on you. If you are a young working professional saving for long term goals, your risk capacity will be high as you would have time on your side to recover from any market downturns and no dependants to worry about. Risk capacity keeps changing with changing circumstances.
Risk profiling helps us decide the amount of debt and equity funds in your portfolio. Higher risk level portfolios have a larger portion invested in equity mutual funds. They can potentially give higher returns in the long run but can experience larger fluctuations too.
It is, also, very important to ensure that the risk level of your portfolio is in sync with your investment time frame. Longer time frames give you the best chance of recovering from any short-term market fluctuations. If your investment time frame is very short, it might be better to have a lesser proportion of equity in your portfolio. So, the amount of debt and equity funds in your portfolio is decided by your risk level in line with your investment time frame. That’s why we recommend different portfolios to different clients.
