Nowadays, lot of financial planners and investment advisors are going
for risk profiling for their clients before giving them investment
advice. Also, as per SEBI (Investment Advisers) Regulations, investment
advisers are required to follow this exercise of Risk Profiling for
their clients before recommending any investment.
Let us understand what is it.
What is Risk and Risk Profiling?
Risk means ‘chance of a loss’ or can be described at an act or a
decision that may cause a loss. ‘Risk profiling’ is testing the
willingness of a person to take risk. Asking the client few sets of
“What if” kind of questions in different situations and scenarios; and
also few questions on the client’s investment decisions are integral to
risk profiling. Answer to these questions helps the planner to assess
the risk taking capacity of the client and identify the risk profile of
the client. There may be clients who can be completely risk averse while
some can be risk seeker. For example, if the risk profile of a client
is assessed as ‘conservative’, means that the client is not willing to
take much risk and usually invests in fixed return investment
instruments.
Willingness and Ability to take risk
Willingness to take risk differs from client to client and his/her
attitude towards risk. Willingness to take risk can be assessed by risk
profiling which helps the planner to understand how much risk the client
can take or how conservative or aggressive is the client with respect
to his investment decisions.
Ability to take risk is completely different from willingness to take
risk. Ability of a client to take risk can be assessed from the client’s
financial position / status, nature and time for the goal. A client can
be risk seeker, but his financial condition and obligations may not
allow him to take risk. So, in that case his investments should be
conservative.
Risk Profiling and Financial Planning
We all know
financial plan is a road map for achieving the financial goals. The
assets of the clients are allocated towards different goals and fresh
investments are recommended for achieving these goals. Generally risk
profiling is done for recommending the asset allocation of investments
necessary for achieving the financial goals. But, is risk profiling
really helpful?
Lets take an example, if a planner has assessed the risk profile of a
young client to be conservative (i.e. risk averse) and wants to plan for
his child’s higher education after 15 years and the inflation adjusted
corpus comes to Rs.30 lakhs. He has a very tight cash flow due to his
existing home loan and has monthly surplus of Rs.5,000. So, considering
his risk profile he should be recommended investment of 80% debt and 20%
in Equity. Assuming weighted average return of 9.40% p.a. from such
investment, he should invest Rs.7,650 per month to accumulate the
desired corpus. While the same corpus may be achieved by investing 90%
in equity via Mutual Fund SIP and 10% in Debt instrument since the time
horizon is 15 years he can take risk. Assuming weighted average return
of 14.30% p.a. from such investment, he should invest Rs.4,800 per
month. So, how will he accumulate the desired corpus if he invests as
per the risk profile? How will he meet the shortfall in his required
monthly investment amount? He may have to compromise on his son’s
education in future since there will be shortfall. The returns may not
be guaranteed in either of the strategies; also there is a certain
amount of risk too attached to the latter investment strategy and
requires periodical review. But the risk taken would provide additional
rewards and may help him achieve the corpus.
So, I don’t think risk-profiling complements the financial planning exercise. In cases where there are multiple financial goals, it can be very difficult to achieve all the financial goals. Also, investment in risky assets cannot be recommended for short-term goals even if the client’s risk profile is aggressive. Thus, risk profiling and financial planning doesn’t seem to go hand-in-hand. But yes, it can be a support mechanism, which will enable the professional planner to understand his client in a better light.
So, I don’t think risk-profiling complements the financial planning exercise. In cases where there are multiple financial goals, it can be very difficult to achieve all the financial goals. Also, investment in risky assets cannot be recommended for short-term goals even if the client’s risk profile is aggressive. Thus, risk profiling and financial planning doesn’t seem to go hand-in-hand. But yes, it can be a support mechanism, which will enable the professional planner to understand his client in a better light.
But recommendations can certainly be not based just on client’s risk
profile as it may have certain restricting factors with respect to his
age, income and time horizon of his goals. Whereas it is paramount that
financial planner / investment adviser takes all these aspects into
account before basing his recommendations.
