Risk profiling helps the financial planner in understanding the probable reactions of investors in future likely scenarios.
Risk profiling is the first and foremost step in the process of financial planning. It is the process of evaluating the ability and the willingness of an individual to take risks. The risk profile of each investor varies from the other. Basis the risk profile, the financial advisor recommends an appropriate asset allocation mix for the investor.
Every asset class (Equity, Debt, Commodity, Currency, and Alternates) has a different risk-reward mix. The right mix of asset allocation helps optimize returns, reduce risks and align the investment time horizon to meet the financial objectives. Risk profiles also helps financial planners in gauging the suitability assessment of the various products within each asset class. For instance, an investor might have the risk profile to take some exposure towards equity, but within the equity asset class, the risk profile might allow the investor to take exposure only towards large-cap companies.
Risk profiling can be measured with the help of a questionnaire. This questionnaire usually captures three key aspects:
a) Current situation of the investor – This covers variables like age, monthly income, stability of income, expenses, number of dependents, and financial goals.
b) Past knowledge and experience of the investor – This includes current exposure in the various asset class, experience, and knowledge of various financial products, along with the number of years invested in various financial products.
c) Attitude of the investor to various situations – This vector helps gauge the investor's ability to think and express the likely reaction to various scenarios. This also helps in determining the risk tolerance of the investor.
Once the risk profiling questionnaire is completed by the investor, the financial planner evaluates the answers and determines the risk profile of the investor.
Broadly there can be three risk profiles:
a) Conservative – Investors having a conservative risk profile have a very low-risk appetite. Their portfolio should be oriented towards capital protection with minimal risk to the principal invested. Investments should be largely in asset classes with low prevalent risk and allocation of the asset should be determined in such a way that in bad market conditions, the risk on the principal is minimized.
b) Moderate/Balanced - Investors having a moderate risk profile have an average risk appetite and are willing to expose a meaningful portion of their portfolio to asset classes with higher prevalent risk to generate potentially higher returns than the Conservative portfolio.
c) Aggressive - Investors having a very high-risk appetite are willing to expose a large portion of their portfolio to asset classes with higher prevalent risk to generate potentially higher returns than the 'Moderate Portfolio''.
One of the key pitfalls for investors while evaluating risk profiles for themselves is risk perception. Risk perception can change with time, situation, experience, etc. Investors might buy more equity during a bull run or reduce equity exposure drastically during the bear market. While the risk tolerance/appetite of the investor during the bull and bear market is the same, what changes are the risk perception. This change in risk perception can result in deviation from the asset allocation per the risk profile which in turn results in diversion from the pre-determined financial plan.
Summing Up!
The risk profile of an investor can change over a period of time. Changes in any of the three aspects of the questionnaire described above can affect the risk profile. It is recommended that risk profiling should be evaluated once every year. Additionally, in case of any change in the risk profile, one should also re-assess the asset allocation strategy and product suitability.
The risk profile of an investor is an important starting step in the financial planning journey and should mandatorily be done before making any investment decision. If you aren’t sure how to do that and you want to discuss you and your family's financial requirements, contact me, I will be happy to help with whatever questions you may have.
Rob.
E:robert.gourlay@holbornassets.com T:(+6) 01151565649 W:www.rgwealthsolutions.com
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