Any investing strategy involves a prominent factor which influences the investing decision to a great extent which is the risk factor. The clients have to be extra cautious while spotting the correct avenue for putting their money in order to get maximum profit from it. Each client has different investing needs and so is their risk bearing capacity. Though mutual funds have a reduced risk factor associated with them, but still there are different levels of risks followed by each of the scheme. For example, equity-oriented schemes are more prone to risks as compared to any other mutual fund scheme.

Risk profiling is the process of ascertaining an investment strategy aptly taking into account the risk factor. A sound and well planned risk profile enables the clients to understand their capacity to take risk and at the same time allows the fund managers to know the kind of funds are suitable for them. The three aspects which determine the risk profiling of a client are as follows:

1. Risk required – It is the risk which has been associated with the scheme. In order to invest in that scheme the client would be required to take that risk. If he/she agrees to do so then that defines the capacity of the clients.
2. Risk capacity – This factor defines the extent up to which the client is able to take risk. Based on which the fund managers decide the perfect scheme for the clients.
3. Risk tolerance – It defines the willingness of a client to take risk. Mutual fund schemes have different levels of risks associated with them as discussed earlier. Hence, it is solely a clients decision whether or not to invest taking the risk factor into consideration.

Noteworthy points to keep in mind while determining risk profile

There are a lot of things involved which are to be looked after while building up a risk profile for the clients. There are following points which should be adhered to maintain a balanced portfolio for the investors investing in mutual funds.

• A mutual fund manager should not blindly rely on the past performance of a scheme. But, should make use of the derivatives to calculate the future performance of the scheme. It implies that noticing the expected returns is equally important to identify whether or not a mutual fund plan is worth taking the risk involved with it.
• Financial goals are an important aspect involved in taking a correct investing decision. If a client invests more in short-term schemes and relatively less for the important goals of life like retirement and child’s education, then it would adversely affect the returns. This is because when you have bigger financial goals, you tend to invest in risk-prone schemes to earn higher capital gains. Thus, if you invest a meager amount in them, then the corpus would also be less.
• Timely monitoring of the investments is another very important aspect to be kept in mind for an efficient risk profiling. Constant check allows the fund managers to identify and remove those mutual fund schemes from the clients portfolio which are riskier and are incapable of producing returns as per the risks involved. Thus, rebalancing the portfolios timely will give way to efficient risk management.
• A fund manager appointed by a mutual fund company must prepare a questionnaire in order to identify the risk-bearing capacity of the clients. The fund manager must be smart enough to frame questions which will give a complete overview of the client’s needs and his/her expectations from the investment they intend to make.
• It is also necessary to understand that even if a couple is investing in any of the schemes both their risk tolerance would be different. But, often it is seen that their risk bearing capacity is clubbed. It leaves one of them unsatisfied and disinterested in mutual fund investing. Thus, it is necessary to calculate risks differently for clients and suggest schemes accordingly.

Difference between risk tolerance, risk capacity, and risk required

As explained above the three factors of risk profiling are the keynotes of deciding the risk profile for any individual client. But, these three are very different concepts. Risk tolerance and risk capacity are related to clients while risk required are related to the scheme. All the three factors from client to client and scheme to scheme. The fund managers and clients both need to be very careful about risk tolerance and risk capacity, as the former can be greater than the latter. Even if the risk tolerance is greater than risk capacity the client cannot invest as he/she does not have the balance to do so. Thus, it is necessary to assess all the three aspects separately.

Therefore, the fund managers and clients as well have to be very attentive while designing their risk profile. It is necessary to have your risk profile generated before commencing investment in a mutual fund.

The risk profile makes it easy for the fund managers to identify the suitable scheme for the clients. The risk tolerance defines the willingness of the clients to take risk while the risk capacity identifies their ability to take risk. For example, if the risk capacity is higher than the risk tolerance, then it becomes easy for the clients to invest in any of the scheme and vise-versa