Risk Profiling

An investor thinks only about RETURN on investments. However, the word RISK is rarely understood. Like fingerprints, investment profiles of people are always unique. Age, Life stage, income, savings, dependents and mindsets are factors that define a person’s attitude towards investments. Risk taking ability and mental frame of mind plays a key role in determining where the investor ultimately puts his money.

The first step in asset allocation is `Risk Profiling’. Risk Profiling combines two key areas –

1. Estimating financial risk-taking capacity and
2. Understanding the (psychological) risk tolerance level of an individual.

Risk profiling can unlock far more value for both investor and financial advisor. It provides advisor clear understanding of investor’s mental frame of mind and his personal and financial circumstances.

Risk Tolerance test helps financial advisor to make judgments about investor’s financial possibilities. It helps to understand investor’s attitudes toward investment risk. Many advisors collect data that helps to assess investor’s attitude towards Risk. As investor’s asset allocation is chalked out as per the risk tolerance it is important to get the basic facts right through series of detailed questionnaire. Analysis of risk profiling can generate following risk tolerance level. The range is indicative only.

Conservative = Highly risk averse

Moderately conservative = Risk Averse

Moderate = Risk Neutral

Aggressive = Risk tolerant

Very Aggressive = Risk seeker

Investor’s existing investment can be altered based upon the outcome of Risk Profiling. E.g. an investor Mr. A (age 30 years) has 90% investment in fixed income securities and 10% investment in equities. He has a steady job in a multinational pharmaceutical company, no liabilities, two dependent in his family (wife & a son), adequately insured for life and health. Although, Mr. A is a risk taker, his investment is tilted towards fixed income, returns on which may not be good enough to achieve financial milestones set by him. His existing investment can be restructured to include more of equity component and his investment in fixed income can be reduced. Risk profiling exercise reveals that he falls into `Aggressive category’ but his existing investment is into `Moderately conservative category’.

Another investor Mr. B (age 58 years) has 80% investment in equities, 15% in fixed income securities & 5% in gold. He is planning to retire in next two years. As per the latest valuation of his overall portfolio, he has almost achieved the retirement corpus that he planned for retirement at the age of 60 years. He wants to maintain the same lifestyle post retirement. He has no liabilities and his only son is well settled abroad. He does not have steady income stream (apart from his salary income, which he is going to lose after 2 years) from any other source. As per his Risk profiling, he falls into `Moderately conservative’ category. However, his existing investment is `Aggressive’ in nature as his exposure to equity is quite high. Considering the fact that he requires steady inflows post retirement, he needs to sell substantial part of his equity holdings and move funds to debt investments.

There are different life stages for an investor and at each life stage his risk profile could be different. Risk profiling helps investor to find appropriate asset allocation strategy at different stage of life