Risk profiling is an integral part of the financial planning and investment advisory process. Nowadays Risk profiling has also become a regulatory requirement as SEBI has made it compulsory for Registered investment advisors.
Investment advisors can advise on asset allocation and suitable investments only as per the Risk tolerance level of the investor. This post is regarding what risk profiling actually is, why it is important and how risks tolerance level leads to a suitable asset allocation.
What is Risk Profiling?
The term risk has a different meaning to different people. Many calls it uncertainty, many calls it an opportunity. Many people assume it as a chance of loss.
In simple terms, risk means a possibility of having 2 outcomes of an activity or action out of which one can be favorable and other can be unfavorable. So where there is a chance of loss, it also has an equal chance of gain too.
Risk profiling is the evaluation process to find out individual’s willingness to take the risk. This process defines the risk tolerance level of the investor after taking into account the understanding and acceptability of risk in different situations of life.
Though the risk profiling is mainly meant to make investment decisions it is derived from reactions to different life situations. For e.g. your acceptance of job which offers salary as 50% fixed and 50% variable or habit of driving your vehicle above the speed limit surely impacts your risk tolerance in investments.
Risk tolerance score comes out after taking into account not only the psychological factors but also your investment horizon and Investment objective.(Read more: Risk in safe investment Case study)
Risk Tolerance Vs Risk Perception
Sometimes an investor enters in the stock market believing that his risk tolerance level is very high and thus ready to bear the volatility. The same investor starts blaming the government, economy, inflation or may start calling equity investments as gambling in the market downturn.
Why so? because he’s misjudged his risk tolerance level. He enters with a perception in mind that he’s young or having a good inflow of money or having very long-term goals etc. so he should be very high in equity allocation. But after a few months he found that he could not handle the real volatility. So what actually has changed in these months is his risk perception.
Risk Perception is what you as an investor personally feel about your risk tolerance level. Buying more when markets are moving up and selling more when markets are going down is the result of your personal risk perception. Research has shown that bull and bear market phases hardly change the risk tolerance level of investors, but what changes in the risk perception. Clients who are not following a proper process in their investments often fall prey to their wrong decision-making due to their own risk perception.
Research has shown that bull and bear market phases hardly change the risk tolerance level of investor, but what changes in the risk perception. Clients who are not following a proper process in their investments often fall prey to their wrong decision making due to their own risk perception.
Why risk profiling is important before making investments?
One of life’s most unpleasant surprises is to discover you have suffered a significant loss because you underestimated the risk involved. Similarly, it can be almost as disappointing to find you have not made the most of your opportunities because you overestimated the risks involved.
While making investments, it is as important to understand your reaction to different outcomes as it is to understand the probable outcomes. Risk profiling is just like basic Blood Pressure check , to decide on how fast you can or should walk/run on a treadmill, When to slow, when to stop.
How risk profiling leads to suitable Asset allocation?
The main reason of doing risk profiling is to figure out a suitable asset allocation as per your risk tolerance level.
Suitability of Investment advice has also become the prime concern of regulators and this is one of the reasons it came up with the regulation of Investment advisors (Read : Is your Investment advisor registered with SEBI?). And thus it is very important for investors to understand the suitability of an investment portfolio.
The Composition of investment assets in a portfolio should be commensurate with the risk tolerance level of the investor. Defensive and growth assets should be adequately distributed in the portfolio. Once you know how much volatility can you handle then only you can decide what equity allocation you should have and in what funds.
Also, Read my article on Money control where I have discussed how to measure Mutual funds risk.
We at Good Moneying Financial Solutions use Finametrica, an Australia-based, psychometric risk profiling tool that provides us with deep insights into the risk and returns involved in different asset allocations. It also tells what fall can be expected from different portfolios and what gains it has generated in past years. It provides a good base to design a suitable investment asset allocation for clients.