Investing is managing and improving your personal finances. Since it’s personal finance we are talking about here, understanding yourself and your situation will help you invest your money in a manner that works best for you.

Before you start searching for the best investment options, it’s important to understand your own risk profile otherwise you might jeopardize your goals.

This means that understanding your risk appetite is an important step, without which you might find yourself over or under exposed to risk. If you are not comfortable with the risk level of your investment you will keep acting impulsively and fail to achieve your goals.

Risk Profiling is a basic and fundamental tool used to determine how you should allocate your assets after analyzing your personal financial situations and balancing it with your goals and objectives. Opting for an investment that fits your risk profile should keep you away from financial ruin.

Your risk appetite constitutes of two main elements:

• Risk Capacity
• Risk Tolerance

Risk Capacity

Risk capacity is your ability to handle risk. It has to do with whether for a given level of risk, the investor’s financial situation can withstand the impact of a worst case scenario. In other words – is the investor able to take the risk without impacting his or her current financial situation or not?

Risk Capacity is the only absolute measure as it is based on your own financial situation, and therefore takes precedence over risk tolerance. Your risk taking ability can be measured clearly by taking the following factors into account:

• Your current net-worth
  How much money can you spare and invest? How much of it can you afford to lose? It is about if you have enough assets to handle capital loss or not. If your investment money is the surplus money that you want to put to good use and earn more, then you can afford to take high risk with that money by investing that amount in riskier instruments like equity and earn those high returns. But if the loss of that money will stretch your finances to the breaking point, than you should opt for capital protection instead of growth and park your money in more conservative instruments like debt funds etc.
  Increase or decrease in net-worth of the investor will increase or decrease their risk capacity. Wealthier investors can usually take on more risk. Sadly, those with little or limited net worth are often drawn to riskier investments in hope of quick and large profits, and mostly end up losing all.
• Your income streams
  If you have a regular income stream than you can afford to take more risk. This is because if the things go downhill you can still find additional funds in the form of your income. But if you are retired or not enjoying a regular inflow than you can’t afford to take high risk, as you will be depending on your investment as the only source of income and can’t afford to handle losses.
• Your time horizon
  Another important factor that determines your risk capacity is the knowledge of how soon you need the money you are investing. The length of time remaining until you reach your goal matters when you are deciding how much risk you can handle in your portfolio. The longer your time horizon, the more risk you can assume, since you have enough time to recover from a loss and vice versa.
  If you need the money in few months time, then you need to invest far more conservatively compared to if you can invest the amount for say a decade or more. Hence you need to select the portfolio that fits you, it’s unwise to pick a risky-heavy stock-oriented portfolio if you need the money within months. Similarly going too conservative when you have long term vision is a bad idea.

Risk Tolerance

Risk Tolerance is your willingness to handle risk. It is psychological and expresses how an investor feels emotionally about taking risk. In other words risk chosen by the investor based on their personality characteristic. It has nothing to do with your financial situation and every thing to do with your state of mind. Risk tolerance is difficult to estimate as it is not concrete or quantifiable. It changes with investor’s emotions. For example, risk is underestimated in bull market and over estimated in a bear market, by the same investor. Risk tolerance usually depends on following factors:

• Perception
  Perception plays a huge role in determining the willingness of an individual to take risk. For example, an individual may be willing to keep all his spare money in Bank FDs even if he is getting low returns from them, than transfer that money into liquid or short term debt funds and earn more. This is because he does not know much about this new type of investment and presumes that they will be a risky, although in reality the risk factor of FD and liquid funds is almost the same.
• Experience
  Understanding the comfort level of risk for investment is more difficult for new or first time investors as compared to existing investors. It is quite possible that due to lack of experience a person might consider himself risk-savvy when in reality they might be risk-averse. This is because it’s really hard to understand what you are comfortable with unless you have experienced losses. Therefore, it’s best for new investors to tread carefully with their money. They should get some experience under the belt before committing too much capital.

It is the first and foremost responsibility of your financial advisor to find the perfect mix of investments after understanding and taking into consideration both your risk capacity and risk tolerance. It is quite possible that you have the ability to take on high risk but are unwilling to go beyond conservative instruments. Or that you are willing to place all you money in risky investment but you can’t afford the losses. A good financial advisor will find the best trade-off and help you achieve your goals based on your risk profile.

There are some firms out there which do not take risk appetite of an investor into consideration and have a fixed standard portfolio of funds for everyone. They justify this by saying something like “Everyone’s objective is the same – to make money”.

I personally find this approach repulsive. Every investor should have a customized portfolio depending on their unique risk profile rather than a standard portfolio thrust upon everyone. What do you think?