Risk Profiling of Investors & Asset Allocation (Life Cycle Model)

29/06/2021 0 By indiafreenotes

Risk profiling is important for determining a proper investment and asset allocation for a portfolio. Every single person has a different risk profile as the risk appetite depends on psychological factors, loss bearing capacity, investor’s age, income & expenses and many such other things.

A risk profile is an evaluation of an individual’s willingness and ability to take risks. It can also refer to the threats to which an organization is exposed. A risk profile is important for determining a proper investment asset allocation for a portfolio. Organizations use a risk profile as a way to mitigate potential risks and threats.

Traditional finance uses the concepts of classical decision making, modern portfolio theory, and the capital asset pricing model (CAPM) to define the risk profile of an investor. In this model, investors are inherently risk averse and take on additional risk only if they judge those higher anticipated returns will compensate them for it. One of the fundamental results of modern portfolio theory is that, under the assumptions of the CAPM (Sharpe 1964), all investors invest in a combination of the risk-free asset and the market portfolio. The allocation of funds between the risk-free asset and the risky market portfolio is determined only by the risk aversion of the investor. Thus, in the world described by this traditional model, the investor’s risk profile is given by the risk aversion factor in the utility function of the investor.

Risk capacity applies to the objective ability of an investor to take on financial risk. Capacity depends on objective economic circumstances, such as the investor’s investment horizon, liquidity needs, income, and wealth, as well as tax rates and other factors. The primary distinguishing feature of risk capacity is that it is relatively immune to psychological distortion or subjective perception. Risk aversion, however, may be understood as the combination of psychological traits and emotional responses that determine the investor’s willingness to take on financial risk and the degree of psychological or emotional pain the investor experiences when faced with financial loss. These emotional factors are often even more important for practitioners to understand than the objective economic circumstances of the investor; yet, they are harder to measure.

Aggressive

Willing to take significant risks to maximise returns over the long term

*Possible Allocation – Equity: 90-100%; Debt and others: 0-10%

Moderately Aggressive

Seeking to maximise returns over medium to long term with high risk

*Possible Allocation – Equity: 70-90%; Debt and others: 10-30%

Moderate

Looking for relatively higher returns over medium to long term with modest risk

*Possible Allocation – Equity: 40-60%; Debt and others: 40-60%

Moderately Conservative

Willing to take small level of risk for potential returns over medium to long term

*Possible Allocation – Equity: 10-30%; Debt and others: 70-90%

Conservative

Seeking safety of capital, minimal risk and minimum or low returns

* Possible Allocation – Equity: 0-10%; Debt and others: 90-100%