Understanding Mutual Fund Risk Profiling

Risk profiling + Riskometer = Successful financial planning

Mutual fund advertisements carry a disclosure on risks. Mutual fund schemes were labeled as blue (low risk), yellow (medium risk) and brown (high risk). Ever wonder why? These are indicators that help investors take decisions in line with their risk profile and investment objectives.

Entrenching the practice deeper, capital market regulator Securities and Exchange Board of India has advised to use the riskometer w.e.f. July 1, 2015, as a replacement for colour coding. What does this change mean for investors? Why is risk profiling important? This article answers the two questions in detail.

The Riskometer:
Under the new system, a 180-degree scale and arrow will be used to help investors take a decision based on their risk appetite. The riskometer will have five categories as opposed to just three earlier:

1. Low - principal at low risk
2. Moderately low - principal at moderately low risk
3. Moderate - principal at moderate risk
4. Moderately high - principal at moderately high risk
5. High - principal at high risk

The new format increases the gradient of risk for profiling mutual fund schemes as the needle moves from low to high risk. The riskometer will be displayed in the scheme information documents, the common application form and advertisements for the scheme.

The Association of Mutual Funds of India has issued broad guidelines to mutual funds to classify the risk profile of funds as follows:

Understanding risk profiling:
Risk profiling caters to investors assessing themselves on various parameters to evaluate their risk-taking capacity and, accordingly, allocate money to different asset classes.

Usually, risk profiling is undertaken by the financial planner through a formal questionnaire-based process where investors have to answer questions that probe their risk-taking capacity and suitability. Important parameters that help gauge an investor’s risk profile include age of the investor, dependents, financial commitments, investment horizon, liquidity requirements, loans/ liabilities, stability of income, time horizon and understanding of investments and financial markets.

Benefit of risk profiling:
Take a look at this hypothetical example: Nitin and Ajay, both 30, plan to retire by 60. Both have a moderate risk profile and invest Rs 10,000 every month until they reach that age. Nitin, despite having a reasonable risk-taking capacity, invests only in debt asset class. Ajay, who is clear about his risk profile, allocates his corpus between equity and debt asset class in a 2:3 ratio. No prizes for guessing who wins. Ajay ends up with a whopping Rs 1.68 crore more in his retirement kitty compared with Nitin.

Summing up:
The mutual fund universe is huge and, hence, investors can use the new riskometer to choose schemes which are in sync with their risk appetite. The riskometer will be particularly useful to investors who are new to the world of mutual funds. In addition, investors are advised to consult their financial advisor and check other criteria such as portfolio attributes and performance parameters before investing.

Growth rate assumptions based on:
20-year average daily rolling returns of S&P BSE Sensex since July 1979 for equity asset class
Average of term deposit interest rates (5 years & above maturity) since 2000-01 for debt asset class (Source: RBI)

Disclaimer: Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content herein has been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader.
Investors should consult their financial advisers before taking any investment decision.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.