Why Should You Understand Your Risk Profile Before Investing?

“With great power comes great responsibility” — this is a famous quote from the movie Spiderman. This applies to almost everything we do. There are always two sides of the same coin. This principle applies even to every investment decision we make. An investment starts with two factors — one is the return as every investor wants more and more, and the other is risk, which everyone wants to avoid. You must understand that these factors go hand in hand and it is not possible to eliminate the risk while getting higher returns, but you may reduce it by effective planning. Although it is easy to understand the returns by looking into the instrument’s past performance, it is hard to analyse the risk profile of the investor. Someone who understands the risk and analyses his/her own profile will be rewarded by finding the right instrument to invest in.

“There is no such thing as a free lunch”. Had it not been the risk involved in investments, then every investor would have probably liked to invest in a probable high-return instrument. However, it is the risk which keeps them segregated. While investing, looking for the returns only is like seeing the half-truth, and the half-truth may give you more bruises than a complete lie.

What if you ended up investing in an FD? Then you may remain bothered about not beating the inflation, or what if you invested in aggressive Mutual Funds for higher returns when every equity market move gives you a headache? In such cases, your investment may not be good for you.

Every investment is done to ease the investor’s life, and knowing the risk appetite is the first step one should take before investing. So what is Risk? Risk is determined as, how much you can afford to lose or how much investment deterioration you can see in your investment portfolio. Analysing your risk appetite and comparing it with the returns will bring the investors onto a path which is right for him/her. Every single person has a different risk profile as the risk appetite depends on psychological factors, loss baring capacity, investor’s age, income & expenses and many such other things. One investment instrument may be good for an investor, but may not be good for others. It all depends on the risk profile. Knowing your risk profile would lead you to the right investment, but if you don’t go for it first, then you are taking your first step in a wrong direction which may lead you to uneasy situations. For instance, if a slight downward movement in your equity/mutual fund portfolio gives you stress, then you may end up eroding your investment by selling it impulsively.

A person in his/her early 20’s may invest in a comparatively higher risk investment instrument where returns are higher, but this decision cannot be taken by a retired person living on his/her pension as they can’t afford to lose their only living option. For the former person, it may be good to invest in Mutual Funds or Equities where he/she can expect a higher return with comparatively higher risk, but for the latter, an FD or a debt instrument may be a good option to invest in. So this is how an investment decision should be taken after analysing both the risk profile and returns and not by luring only into higher returns where you may trap yourself into if you don’t know your own risk profile.