Table of Contents
Risk profiling for investors and risk profiling approach:
Different people have different appetites for taking risks. The willingness to take risks is influenced by an individual’s psychology, financial circumstances, and the resources available to them. Risk profiling is used to measure a client’s financial risk tolerance and understand their risk preferences.
Risk Profiling for Investors:
Risk profiling is the process of assessing a client’s risk tolerance levels. It involves measuring their attitudes, values, motivations, preferences, and experiences with risk. Risk profiling is typically done using questionnaires that estimate an investor’s ability and willingness to take risks. The responses of investors are converted into a score that may classify them under categories that characterize their risk preferences.
Risk Profiling Approach:
The following example illustrates how different people have different appetites for taking risks:
A person is offered a chance to play a game in which a coin will be tossed. The person pays Rs. 1,00,000 for one chance to play the game. The person can choose to call “heads” or “tails”. If the coin comes on the person’s choice, he wins Rs. 1,10,000. As per statistical analysis of the above game, the person stands to win Rs. 5,000/- every time he plays the game (i.e. 50% probability of losing Rs. 1,00,000 equals Minus Rs. 50,000 plus 50% probability of gaining Rs. 1,10,000 equals Rs. 55,000; the net payoff amount is thus Rs. 5,000).
Factors Affecting Risk Appetite:
Risk appetite is influenced by various factors such as family information, personal information, and financial information. Table 18.1 below summarizes these factors and their influence on risk appetite.
Factors Affecting Risk Appetite
|Factor||Influence on Risk Appetite|
|Earning Members||Risk appetite increases as the number of earning members increases.|
|Dependent Members||Risk appetite decreases as the number of dependent members increases.|
|Life Expectancy||Risk appetite is higher when life expectancy is longer.|
|Age||Lower the age, higher the risk that can be taken.|
|Employability||Well qualified and multi-skilled professionals can afford to take more risk.|
|Nature of Job||Those with steady jobs are better positioned to take risk.|
|Knowledge about Markets||A person who is better informed about markets is in a better position to take market risks, than someone who is ignorant about them.|
|Psyche||Daring and adventurous people are better positioned mentally, to accept the downsides that come with risk.|
|Capital Base||Higher the capital base, better the ability to financially take the downsides that come with risk.|
|Regularity of Income||People earning regular income can take more risk than those with unpredictable income streams.|
Parameters for Risk Profiling:
- Risk profiling tools are available on websites, but some suffer from investors guessing the right answer instead of being truthful in their answers, which defeats the purpose of risk profiling.
- Advanced risk profilers assess risk profile based on actual transaction records of regular clients, which is more accurate.
- It is important to understand the limitations of risk profiling tools before using them in practice, and investment advisors need to use them judiciously.
- The SEBI Investment Adviser Regulation 16 requires investment advisors to ensure that clients’ risk profiling is done before providing investment advice or recommending investment products.
- Relevant information such as age, investment objectives, time frames, income, existing investments, innate ability to take risks, and details of loans need to be obtained to assess the client’s innate willingness and ability to take risks.
- Tools or questionnaires used for risk profiling need to be fit for purpose, fair, clear, not misleading, and not contain leading questions.
- Risk profiling needs to be done before any investment advice is provided, and clients’ risk profiles need to be updated periodically based on changes in family composition, income/expenses, or assets/liabilities.
Classification of Investors:
- Conservative investors prefer safe income-yielding instruments and are new to risky instruments.
- Moderate investors have some experience investing in risky assets and understand they need to take risks to meet their long-term goals.
- Aggressive investors are experienced investors willing to take on investment risks and understand the importance of generating long-term returns.
Role of Risk profiling in Asset allocation-
|Role of Risk Profiling in Asset Allocation|
|– Asset allocation refers to the distribution of an investor’s portfolio between different asset classes.|
|– Risk profiling is a process of determining the investor’s ability to take risks, need for growth, income, or capital protection, and investment horizon using questionnaires and other tools.|
|– Asset allocation should be aligned with the investor’s financial goals and risk profile.|
|– Efficient asset allocation includes asset classes with low or negative correlation to reduce the risk of being invested only in an asset class that has performed poorly.|
|– Strategic, Tactical, and Dynamic Asset Allocation are three types of asset allocation.|
Investor’s risk profile with the asset allocation-
|Investor’s Risk Profile with Asset Allocation|
|– An investor’s risk profile should be considered while creating an asset allocation plan.|
|– Strategic asset allocation is a long-term plan based on the investor’s goals and risk profile, which is periodically reviewed for continued relevance.|
|– Tactical asset allocation involves taking a higher exposure to equities or other asset classes based on market expectations, and is suitable for seasoned investors.|
|– Dynamic asset allocation uses pre-defined models to allocate assets among different asset classes based on triggers for reallocation, such as asset class valuations or portfolio performance.|
|– Asset allocation and investment policy can better explain portfolio performance than the selection of securities within an asset class.|
Model Portfolios for Different Client Profiles-
|Client Profile||Asset Allocation Mix|
|Young call centre/BPO employee with no dependents||50% equities/diversified equity schemes (preferably through SIP); 20% sector funds; 10% gold ETF; 10% diversified debt fund/fixed deposits; 10% short-term debt funds and liquid schemes/savings bank account/current account.|
|Young married single income family with two kids||35% equities/diversified equity schemes; 10% sector funds; 15% gold ETF; 30% diversified debt fund/fixed deposits; 10% liquid schemes and short-term debt funds/savings bank account/current account.|
|Single income family with grown-up children||35% equities/diversified equity schemes; 15% gold ETF; 10% gilt fund; 20% diversified debt fund/fixed deposits; 20% short-term debt funds/liquid schemes/savings bank account/current account.|
|Couple in their seventies with no immediate support||15% diversified equity index scheme; 5% gold ETF; 35% debt-oriented hybrid fund/MIS/SCSS; 30% diversified debt fund/fixed deposits; 15% liquid schemes/savings bank account/current account.|
Suitable Investments Based on Investment Objectives
|Investment Objective||Suitable Investment|
|Growth and appreciation in value||Equity shares and equity funds, Real estate, Gold|
|Regular income||Deposits, Debt instruments and debt funds, Real estate|
|Liquidity||Cash, Bank deposits, Short-term mutual fund schemes|
|Capital preservation||Cash, bank deposits, Ultra-short term funds|
Note: Investors should seek professional advice on the most suitable allocation for their investment objectives and risk tolerance levels. Investing in a single asset category can lead to concentration risk, while diversification can protect the portfolio from the impact of a fall in one or few assets. The process of dividing the portfolio among different asset classes to reduce risk is called asset allocation. Model portfolios can be tailored to suit different client profiles.