Understanding your risk profile
If you have watched an ad for any financial product, you will hear this
A nice Jingle
Voice over of key features and benefits of the product
Happy customers looking lovingly at their kids / grandkids
Kids running around and playing
Contented smiles from the customers
And then a super fast paced blurb that goes something like this “product subject to market risk, read full prospectus before you invest”
So what is this risk that they really don’t want to tell you about.
Everything that we do in life has risks.
Taking a shower
crossing the road (If you live in a metro, i am sure you can relate to this)
We still do it because in most cases we don’t think of them as risks and in others we accept and acknowledge them.
Same applies for financial products. You just need to be aware of those risks before you dive in.
Your risk profile is composed of two things
Aren’t those two things the same?
No. Lots of blogs and advisors use them interchangeable, though they are closely related they are not the same.
Risk Appetite - is your ability or willingness to accept a level of risk towards achieving your goals. This is something you evaluate before investing in a financial product on whether returns that you are hoping to generate from the product is aligned to the risk profile of the product. For example, you purchase a BBB rated bond for ‘x’ rate of return. You are aware of the probability of the bond going default against the rate of return promised.
Risk tolerance - is your ability to accept a certain risk when it actually occurs or be prepared to accept the risk of loss when it actually occurs. For example, if you are buying an stock or index at 100, but you are prepared for it to fall to say 60 a 40% correction, then that is your risk tolerance.
There are some useful questionnaires online that will help you map your risk profile, before going ahead with your financial plan. When filling these up, involve your significant other as well to understand where both of you stand in the risk spectrum. You might be in for some surprises.
A few samples below
ICICI prudential here
Answer these questions honestly and truthfully so that you can evaluate how to tailor your financial plan.
Happy investing and good luck on your FIRE journey. #MyFATFIRE
Thumbnail image - Mike Cohen Flickr