What is risk assessment and how to create a risk management plan

Most investment products carry an element of risk, the difference is the level or degree of risk every product has. An individual's decision whether or not to invest in a particular financial product and how much to invest depends on the risk involved. Usually, the return expectation is also based on risk assessment. The higher the risk, the higher the return expectation. 

In this article, you will learn about risk assessment, the various risks that investment products entail, and ways to mitigate them.

What is risk assessment?
 

In personal financial planning and analysis, the process of risk assessment involves identifying the risks in various investments. The risks are then matched with an individual's risk appetite, and an investment portfolio is built accordingly.

The performance of the portfolio needs to be monitored regularly after it has been made. An individual's portfolio review is an ongoing process until his or her financial goals have been achieved. It involves analysing whether the risks and returns are playing out as expected. If there are significant deviations, corrective action must be taken.

Having understood risk assessment, the next step is to determine what risks different financial products carry and how to match them with your risk profile.

Risk assessment of financial products
 

Various financial products carry various risks. Some of these include:

· Domestic equities:
 

 Equities come with risks such as lower-than-expected return, capital loss, volatility, illiquidity

· International equities: 
 

They also carry risks similar to domestic equities. However, they have an additional risk of currency movements, war, geo-political issues etc.

· Fixed income products: 
 

These carry credit risk, interest rate risk, reinvestment risk, etc.

The next step in the risk assessment process is to match the risks involved in financial products with the investor’s risk appetite.

Investment planning:Individual risk assessment
 

Risk is often associated with outcomes that are opposite or negative to what is expected in individual financial planning and analysis. In most cases, individuals invest in order to make a profit. Therefore, the term risk is usually associated with a loss or a lower-than-expected profit, or the opposite outcome.

An investor’s risk profile can be classified as follows:

· Aggressive: 
 

An individual with an aggressive risk profile can take high risks. An individual’s risk assessment indicates an appetite for suffering losses or receiving lower than expected returns. Individuals with aggressive risk profiles can invest in equities. Usually, the higher the risk, the higher the return expectations. In the past, equities have created wealth for investors through high returns over long periods of time.

· Conservative:

Those with conservative risk profiles do not have the appetite to take investment risks because they cannot bear losses. Fixed-income products are much less risky than equities, so they are able to invest in them.

The government issues some fixed-income products, including government bonds, Employees' Provident Funds (EPFs), Public Provident Funds (PPFs), National Savings Certificates (NSCs), etc. With a sovereign guarantee, they offer the highest level of safety. However, conservative investors have to be content with low to moderate returns.

· Moderate:

A moderate risk profile indicates a certain level of risk is acceptable to the individual. The risk involved with these products is higher than that of fixed income but lower than that of equity. The expected returns from these products are moderate. They can invest in a combination of fixed income and equity products or hybrid products that offer this combination.

Also read: The importance of managing personal finance in empowering women in India

​​Factors that impact the risk-taking ability
 

An individual's risk profile may be high at the beginning of their investment journey based on a preliminary risk assessment. Typically, their risk-taking ability deteriorates with each passing year as they age. The risk profile may also change as certain events occur, such as:

· Financial liabilities: 
 

When an individual takes on a big loan such as a home loan, it may reduce risk-taking ability due to the EMI obligations.

· Responsibilities: 
 

When an individual gets married and has children, it may reduce risk-taking ability due to increased family responsibilities.

· Time left to achieve the financial goal: 
 

As an individual nears a financial goal, they will prefer to shift the money from an asset class with high risk to one with low risk.

Ways of risk management
 

Now that you know how to do a risk assessment of financial products and match them with your risk profile, it’s time to start planning your investments. However, that is just one way of managing risks. Other ways of risk management include the following:

1) Buying life insurance
 

While you will do everything you can to achieve your financial goals during your lifetime, your family may suffer financially if you die untimely and tragically. In your absence, your financial goals, such as your child's higher education, your spouse's retirement, may end in jeopardy. Your family will be protected financially from financial consequences resulting from your untimely death if you buy life insurance. If something were to happen to you, your life insurance policy would provide financial security for your family.

2) Contingency planning with an emergency fund
 

A good idea is to maintain an emergency fund that covers 3-6 months of your regular expenses. This way, you can fall back on the fund if you are laid off from your job, your salary is delayed, etc. You will not have to withdraw money from your long-term investments in the event of an emergency.

It is important to consider lock-in periods of financial products as part of risk assessment. For example, ELSS have a three-year lock-in period, while tax-saving fixed deposits have a five-year lock-in period. In the event of any contingency, you would not be able to withdraw money from an equity and debt combination of these two investment products. Therefore, an emergency fund with a specified lock-in period is essential to mitigate liquidity risks resulting from these and other investments.

You can open an IDFC FIRST Bank Savings Account to build and maintain your emergency fund. Such an account earns you an interest of up to 7% p.a., where the interest is credited monthly. You can open the account online within minutes.

3) Building a diversified portfolio with appropriate asset allocation

It is a good risk management practice to follow appropriate asset allocation and invest in a diversified portfolio rather than relying on a single asset class. Each of these asset classes plays a specific role in the investment portfolio, so be sure to include domestic equities, international equities, gold, fixed income, etc.

Asset allocation provides much-needed diversification. Asset classes take turns to outperform each other. Predicting which asset class will do well next year or later is difficult. In order to achieve optimum risk-adjusted returns, asset diversification is essential, regardless of asset class performance.

Adding equities, gold, and fixed income as assets to asset allocation also provides a hedge. For example:

· Gold provides you with a hedge against inflation

· Global equities provide you a hedge against domestic currency depreciation

IDFC FIRST Bank provides personalised investment solutions and helps you build a diversified investment portfolio with various types of mutual funds depending on your risk profile. You can choose from domestic equity funds, international equity funds, debt funds, gold funds, etc.

Regular review of risks
 

Once you have done the risk assessment of various financial products, matched it with your risk profile, and built a diversified investment portfolio, it continues. Our earlier section discussed how an individual's risk profile can change when specific events occur. You might find it helpful if you did a risk assessment once every six months or once a year. You can add new products, modify existing ones, or remove old ones as necessary during the review. You should continue this regular review process until you reach your financial goals.

Disclaimer

The contents of this article/infographic/picture/video are meant solely for information purposes. The contents are generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. The information is subject to updation, completion, revision, verification and amendment and the same may change materially. The information is not intended for distribution or use by any person in any jurisdiction where such distribution or use would be contrary to law or regulation or would subject IDFC FIRST Bank or its affiliates to any licensing or registration requirements. IDFC FIRST Bank shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information mentioned. Please consult your financial advisor before making any financial decision.