Why Risk Profiling is important in financial planning?

Ever wondered why every financial advisor wants to understand your risk profile and why experts keep talking about it so much? Let’s find out.

Age plays an important role in decisions related to asset allocation, but risk profiling is much more than that. The primary aim of risk profiling is to ensure that investment recommendations of financial planners match an investor’s financial and emotional aptitude to engage in financial transactions.

It should determine –

1. the investor’s risk needs,

2. her ability to take risks, and behavioral investor tolerance.

Let’s understand it with an example.

You stay in Pune and are planning to make a road trip to Mumbai. Before embarking on the journey, you make an assessment of the likely time required to reach your destination based on your past driving experience. This is analogous to the risk needs – how much someone should invest in various risk assets in order to reach his or her goal.

However, while driving, the driver faces limitations. He or she has to maintain the regulatory speed and cope with traffic conditions. It acts as a limiting factor in achieving the goal and cannot be dispensed with; akin to the risk-taking ability of an investor.

Lastly, the driver’s behavioural aspects come into play; whether he drives safely or rashly (and gets pulled over by the police). Similarly, an investor’s behaviour towards losses shapes the outcome of the portfolio strategy.

Each of these parameters – need, ability and behavioural loss tolerance – plays an important role in defining the driving profile of each trip. Similarly, these characteristics help define the investor’s profile and thereby facilitate investment decisions for achieving their goals.

Let’s delve deeper into these three parameters:

Risk need

If you have a child education goal target of Rs 1 crore after 15 years and can save Rs 25,000 every month, then you need a return of 8.3% annually. This required rate of return in turn will define if you need to take high or low risk (through exposure to growth assets).

Here, it is important that financial advisors arrive at a realistic estimate of future returns for all assets based on historical growth rates and market environment.

Lastly, the consequence – financial and emotional threats one faces if a goal is not achieved – cannot be ignored.

The severity of failing to meet a goal should lead one towards alternatives like saving more or working for more years.

Risk-taking ability

It could act as a limiting factor in your exposure to growth assets. Investment horizon is one such sub-factor. If you have only five years to achieve your goals, then you need to compulsorily invest in safer assets regardless of your risk needs, since growth assets come with short-term volatility.

Similarly, risk capacity – your capacity to deal with a financial loss – could affect your risk-taking ability.

For instance, if you are getting a pension or have an alternate source of income in the future or assets to support in case your goal is not achieved, then you have better risk-taking ability than otherwise.

Then there’s liquidity. In the life stage of capital accumulation, your need for liquidity is low, thereby giving you a higher ability to take risks and vice-versa.

Behavioral loss tolerance

It defines the maximum extent of uncertainty one is able to accept and is gauged through tests, interviews and questionnaires.

Financial knowledge and investor experience indicate the level of awareness about products and their experience across market cycles.

Higher scores on these counts indicate investors can graduate towards growth assets if need be. Risk composure indicates the chances of the investor to act in a biased manner on a perceived crisis and that often results in losses. A trigger-happy investor quits stocks on initial signs of market correction while the firm-minded stays put.

When all these three factors are reconciled and related together, a better portfolio strategy is possible.

1. Investor’s risk need cannot exceed investor’s risk-taking ability associated with the goal.
2. Higher risk-taking ability may be discounted when both the need and behavioral loss tolerance is lower.
3. Similarly, a lower risk needs may be discounted when both risk-taking ability and behavioral loss tolerance are higher.
4. And low behavioral loss tolerance can never be ignored.

Takeaway

Risk-profiling is an important exercise in the process of financial planning. Ensure your financial advisor goes beyond the age rhetoric and suggests investment strategies based on these risk metrics.

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