The Importance of Understanding Your Risk Appetite Before Investing in Mutual Fund

Returns and risk are two sides of one coin. You need to take higher risks to improve your chances of getting high returns. Since the capacity to take a risk in mutual fund investments differs from one person to another, the herd mentality doesn't apply here. 

What is a Risk?

It's the extent of unpredictability or loss in an investment. As the risk rises, investors try to compensate for it with higher returns. Risk is determined by various factors like the investor's:

• Age
• Income
• The number of financial dependents
• Expenses
• Load-bearing capacity

One who is younger, has lesser expenses, higher income, fewer financial dependents and high risk-taking capacity might have a higher risk appetite. You must analyse your risk profile and compare it with the returns to understand the most suitable asset classes for your investment. Simply use the risk analyser of a reputed fund house for your risk profile assessment before investing. 

How to Reduce the Risk in Your Portfolio?

After using a risk analyser, consider how to lower your portfolio's risk. For that, diversify your portfolio. Balance it with different asset classes to help lower your risk. Balanced, debt and equity mutual funds can help diversify investments. Equity funds invest in equity markets (small-, mid-, large- and multi-caps). Debt funds invest in money market instruments, government bonds and corporate bonds. They offer higher returns than the conventional FDs. Balanced funds are hybrid instruments of equity and debt to balance these asset classes. 

How to Allocate Assets Based on Determinants of Risk Profile?

• Age: Age goes hand in hand with the number of financial dependents. The younger you are, the higher the risk you can bear since you have fewer responsibilities or financial liabilities. Therefore, it's always a good idea to start investing early. Since equities make a risky section of your portfolio, opt for different equity allocations as per your age.
• Income: It's easy to invest depending on your income. As your income increases, you can invest more. Step up your investment annually by 5-10% to help meet your financial goals sooner, beat inflation and gain high returns in the end.
• Expenses: As you age, expenses increase naturally. So, reduce any unnecessary expenses to invest every extra rupee.
• Risk-bearing capacity: If you panic for every small change in market conditions, you may not be ready to take a risk. Then you must invest in low-risk assets. A risk analyser can help you choose them. If you are bullish about the market and seek high returns, you can bear more risk than an investor bearish about the market.

To conclude, the assessment of your risk profile is crucial before you start investing. Depending on your varying risk profile with changing stages of life, your age and financial responsibilities, you can invest in suitable asset classes. Before that, make sure to use a risk analyser. After knowing your risk-taking capacity, balance out your portfolio and keep changing the allocation across different asset classes over time. Most importantly, consider staying invested for a long time to help beat inflation.