Whenever you approach a good financial planner, he recommends you to undergo a Risk Profile Test. We too do it and consider it a must to arrive at Asset Allocation for an investor. But is it only to know the asset allocation for an investor or Risk Profiling can help know a bit more? Yes, Risk profiles help us to measure/quantify 3 basic things which are often used by financial planners synonymously – Risk Capacity, Risk Required & Risk Tolerance. These 3 comprises of entire risk assessment of an individual.
So Risk Assesment is not just a 12 or 25 question document. It is an entire check of risk or risk aversion a portfolio owner can handle. When a planner is sure of this risk he is actually in a position to determine an asset allocation and can recommend products to invest.
The risk is not a dreaded word and we do risk management all time in life. We jog to minimize the risk of bad health, we check air pressure/coolant before a road journey to avoid the risk of the unpleasant journey. We correct our child some time to avoid the risk of him/her developing bad habits. So we do it all time, but it is a bit scientific and calculative in personal finance.
Let learn how this done:
Risk Profiling
Risk profiling is the process of determining an appropriate investment strategy while taking risk into account. Sound and well thought out risk profiling practices enable advisors to understand their investors’ level of risk aversion. Risk profiling is a process of finding the optimal level of investment risk for your client considering the risk required, risk capacity and risk tolerance.
These are 3 primary aspects of risk, each of which has an impact on the decision-making process:
Risk Required – the risk associated with the return that would be required to achieve the investor’s goals – it is a financial characteristic. It is the risk associated with the return required to achieve the client’s goals from the financial resources available.
Risk Capacity – this means the amount of risk your client can afford to take – It is again a financial characteristic. Beyond this level investor is worried about the risk that he is taking and may show signs of restlessness.
Risk Tolerance – the level of risk the client prefers to take – It is a psychological characteristic. It is the level of risk the Investor is comfortable with.
Risk profiling requires each of these characteristics to be separately assessed so that they can be compared to one another. Risk capacity and risk tolerance both act separately as constraints on what investor might otherwise do to achieve their goals (risk required).
Where a mismatch between risk required, risk capacity and risk tolerance have been found, the advisor’s role is to guide the investor through the trade-off decisions that are required to reach an optimal solution. And this is why we as planner always go for Risk Assessment Test.
The final step in the risk profiling process is to ensure that the investor has a realistic risk and return expectations so that the advisor and investor are on the same page while consenting to implement the investment strategy.
Things to keep in mind
Assess separately: Assess your risk tolerance, risk capacity, and risk required separately. These are 3 different things and portfolio is constructed depending and fall out of all 3 variables. You leave one the Risk Profile gets faulty.
Compare the findings to look for discrepancies in the client’s risk tolerance, risk capacity and the risk required. These are bound to be different as we say “we know something but think something else and and then talk entirely different”. It is balancing mind & action.
Know risk-return trade-offs. For example, if an investor has a very high risk-tolerance but a low-risk capacity, he has to understand the optimum level of risk required to achieve his goals.
Eliciting information: To be able to determine the risk required the advisor must be skilled in eliciting information from an investor about their goals, current and anticipated income and expenses, and current and anticipated assets and liabilities. More information means correct assessment.
Common mistakes that you should avoid
Relying on historical data blindly rather than looking at expected returns in the future. History is gone and factors have changed. Who knew demonetization till mid-2016? Future will definitely not repeat what is in history.
Making insufficient allowances for longevity of life, health care expenses. I had an investor recently who made me recalculate his cash flow in case he and his spouse survive for 100 years against the 85 years that we normally calculate.
Not re-balancing portfolios with regular intervals, resulting in the risk/return of the portfolio drifting away from the risk/return required. I again reiterate asset allocation explains more than 90 percent of the quarterly variation in a given portfolio’s returns.
How is Risk Profiling done?
Risk Profiling is a psychological parameter that is largely dependent on an emotional balance. This can be measured by recording and analyze a series of question aiming at investors past relationships with money.
We Advisors who do not use industry-standard, non-psychometric questionnaires or interviewing techniques will find it difficult to establish objectively that they are making valid and reliable assessments of their investor’s risk tolerance.
Thus, it is crucial that psychometric tests are done and evaluated in order to have a clear understanding of your risk tolerance.
Commonly made mistakes while assessing risk tolerance include
- Vague, wrongly worded questionnaires
- Lack of explanation about the methodology entailed in assessing risk tolerance
- Relying entirely on subjective judgment e.g. an interview
- Jointly assessing the risk tolerance of couples/decision makers rather than assessing individual tolerance
- Ignoring inconsistencies that arise between an investor’s investment tendencies and their answers on questionnaires
3 Situation arises when investors risk tolerance, risk required and risk capacity are analyzed
In about 60% of cases, there is no investment strategy that will achieve the client’s goals, with the desired risk capacity. This is called an undershoot. So given the resources available, the client has overly ambitious goals.
Nearly in further 30% of cases, risk required, risk capacity and risk tolerance are more or less in line.
For the remaining 10% of cases, the risk required to achieve the client’s goals is less than risk tolerance – called an overshoot.
How do you deal with a situation when risk required is more than risk tolerance? – An Undershoot
- The options investor has are (a) Take more risk or (b) Invest more
Increasing the risk is never advised beyond the tolerance level. In that case, the investor has three options, which allow him to address this problem:
1) To commit additional funds during the term of the investment, and/or
2) To extend the time horizon, i.e. delay the goal, and/or
3) To reduce the goal amount
Failing that, the investor will need to accept the fact that underperformance of the investment would mean that the goal cannot be fully achieved in the desired timeframe.
How to deal with an Overshoot? When an investor is reaching or there is a surplus within the risk profile.
If this happens these presents only happy choices. The investor will have options to increase, accelerate or add goals, spend more now or have a less volatile journey.
The Right Portfolio- As per RISK-Return Tradeoff
Risk Perception
Before concluding, it is appropriate to give some consideration to risk perception too.
New investors are usually not well-informed about investment risk. They know the relationship between risk and return, and the range and likelihood of possible outcomes, including the possibility of extreme events.
Investors will make decisions based on their perception of the risks involved.
In a rising market, the risk is likely to be under-estimated and over-estimated in a falling market.
It is critically important that advisors with help of the investor manage investors’ risk and return expectations through education.
To conclude
The relationship between risks and rewards needs a careful explanation to ensure that investors understand how a financial planner is structuring their portfolios through time. The myriad of risks that can affect your investment portfolio can be daunting. Risk profiling is a long process of balancing the uncertainty and possible outcomes.
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