While investing in the stock market or any financial instrument, the first thing that fund managers ask is your risk tolerance level, based on which you will decide whether you can invest in the said investment avenue or not.
But, if you answer by taking the emotional aspect as a base, then you might be doing something wrong with your money because the first rule of investing is keeping your emotions aside and investing by looking at the numbers, as numbers don't lie.
So let's learn the most important skill you need to learn before starting your investment journey, determining risk profile:
Evaluate your financial goals
Think about your short-term and long-term financial goals, such as buying a house, saving for retirement, or funding your children's education. Your goals will influence how much risk you are willing to take.
Additionally, you can prioritise your financial goals based on unavoidability. For example, you cannot avoid retirement planning, so you cannot take the risk of losing capital. You need to have a diversified portfolio with a mixture of debt that minimises risk and equity that helps in maximising returns.
Assess your time horizon
Consider how long you plan to hold your investments. Generally, the longer your time horizon, the more risk you can take because you have more time to recover from potential losses.
For example, you are investing to buy your dream house after a period of 15 years from now. You can invest in value stocks by increasing your investment proportionately every year.
Investing in a value stock for a longer period of time will give you a drastic growth in return than fixed-income securities as the value of money increases with an increase in the industry's growth.
Analyse your financial situation
Evaluate your current financial situation, including your income, expenses, debts, and assets. Understanding your financial situation will help determine how much risk you can afford.
If you have a debt of more than 30% of your income, it is better to focus on paying off your debts and preferably invest in fixed-income securities, as you cannot take the risk of losing capital that you have invested.
Use a risk assessment questionnaire
Many financial institutions provide risk assessment questionnaires to help determine your risk profile. These questionnaires typically ask a series of questions about your financial goals, investment experience, and risk tolerance. The questionnaire will provide a recommendation for your risk profile based on your answers.
Number of dependents
The number of dependents you have in your finances is a significant indicator of determining your risk profile. If you have a whole family to feed and are the only earning member, then investing in highly risky securities is inappropriate. A single financial uncertainty can harm your family considerably.
On the other hand, if you have just started earning and have no responsibility for family members right now, you can invest in equity and take risks in the hope of getting handsome returns.
Keep in mind that your risk profile can change over time based on changes in your financial situation, investment experience, or personal circumstances. It's important to periodically review your risk profile and adjust your investment strategy as needed to ensure that it aligns with your goals and comfort level.
Anushka Trivedi is a freelance financial content writer. She can be reached at anushkatrivedi.com