Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Do you know yourself as an investor?

A clear communication with your financial adviser about your risk appetite is crucial for a sound portfolio

Question: What degree of risk are you willing to take with your financial decisions? Let’s say your choices are: very small, small, medium, large, and very large.

Next question: Think of the average rate of return you expect from an investment portfolio over the next 10 years. How does this compare with what you think you would earn if you invested the money in one-year bank fixed deposits? Your options:

 About the same rate as bank fixed deposits;

 About one-and-a-half times the bank fixed deposits;

 About twice the bank fixed deposits;

 About two-and-a-half times the bank fixed deposits;

 About three times the bank fixed deposits;

 More than three times the bank fixed deposits.

There is a thread that ties up these two questions—ignore it at your peril. The first question asks you how much risk you are willing to take. The second asks you how much return you expect from your investment.

Beware! The mind can play tricks. Now, if you choose to take very little risk but expect your investment to earn, say, ‘About three times the bank fixed deposits’, there is a disconnect. In other words, if you invest in an equity mutual fund (MF), possibly an aggressively managed one, and tomorrow if the market—and your MF—drop sharply, you’ll get a heart burn.

We all love to earn high returns, don’t we? But the question is: are we willing to take as much risk?

Remember, the more risk you are willing to take, the more returns you stand to earn. Risk and return go hand in hand.

And that’s why risk profiling is so important these days.

Why do risk profiling

There was a time when you used to walk in to your distributor’s office with your cheque book and simply invested in something that she recommended, over the counter. But equity and fixed-income markets, especially the former, have been unforgiving these past few years. During 2010 to 2015 calendar years, the S&P BSE Sensex has returned 17%, -25%, 26%, 9%, 30%, and -5%, respectively. It has been a roller coaster. Yet, a rough ride should not change your financial goals. You still have to plan for your child’s education and marriage, your own retirement, and as with most of us, a house. You want returns, but you should also know how much risk you can tolerate.

Enter risk profiling. All investment advisers registered with the capital market regulator Securities and Exchange Board of India (Sebi) are mandated to do detailed risk profiling of their clients. Most fee-based financial planners—who aren’t yet registered with Sebi—also do this.

It is usually done with a questionnaire that your investment adviser gives you at the time of on-boarding. She either emails it to you, which you complete on your own and send back, or she can help you fill the same in front of her.

Financial advisers can either devise their own risk profiling questionnaires or use one from globally renowned vendors who specialise in making these questionnaires. Around 150 Sebi-registered investment advisers in India use FinaMetrica’s questionnaire. FinaMetrica is an Australia-based applied behavioural finance specialist that has devised a psychometric questionnaire, which it claim comes closest to ascertaining an investor’s true risk tolerance. Sebi rules state that all registered investment advisers must do their clients’ risk profiling.

But what if the adviser knows her client well? Is it still important? “Yes," says Deven Shah, an independent consultant supporting FinaMetrica in India. “Most distributors, themselves, have a high tolerance because they are knowledgeable, most are independent in their profession and natural risk-takers. They end up transferring their risk biases to their clients— investors—even though the client may not like that much risk. Psychologically, clients may react to risk differently."

To put it simply, let’s say you want to invest some money. Much of your savings are in traditional fixed-income earning instruments and you still have quite a lot of money left to be invested. So far, say only about 10% of your money is in equities. Should you, therefore, raise your equity allocation now? The yesteryear distributors would say a loud ‘yes’.

The truth is, it’s not a simple yes or no. We probably don’t know yet, because you could still be averse to taking risks. In which case, if she advises you equities, she could be wrong. A risk profile captures the real you. Your fears, anxieties, hopes, expectations and aspirations. “This way you go one step closer to understanding their minds on the basis of the way they answered the questions. It helps us to bond with them and also build the trust, which is the cornerstone of an investment advisors’ practice," says Kshitija Ravi, director, Gaining Ground Investment Services, a Bengaluru-based distributor. At the very basic, risk profiling brings out your risk tolerance (how much risk you think you can take) and risk capacity (how much risk your portfolio allows you to take).

Catch the contradictions

Shah tells us about a Sebi-registered investment adviser who did not do his client’s risk profiling before he applied for and got Sebi’s licence. One of his clients was a wealthy investor, who this adviser says, was “very difficult to deal with." Shah says, every time the market fell, the lady customer confronted the adviser.

When this adviser got the Sebi licence, and was mandated to do risk profiling, he made this client take the test too. “To his astonishment, the lady’s risk tolerance test results said she ought to have just 15% equity exposure and 85% in fixed income. On the contrary, the lady had invested 80% of her corpus in equity and 20% in debt," said Shah. The adviser and the lady went through the test’s answers again and the lady reiterated that those answers were indeed what she wanted. “No wonder, any market fall made her jittery; she was just not cut out for equity markets at that time," Shah points out, as a matter of fact. Now, he says, the adviser rests a bit easy and so does the client, as they reworked the portfolio.

Financial planners say risk profiling gives them valuable insights. The last question in the FinaMetrica risk-profile questionnaire, which Kshitija administers, asks the client to guess their score.

Ideally, if a client guesses a higher score, her risk tolerance is said to be higher. However, Kshitija recalls a client—who runs a startup—that guessed a very high score but had a very low risk profile. Another client—from the merchant navy and loved adventure sports—scored very low on risk tolerance. Why? It turns out that his mother was a banker “who ingrained in him, to not take risks with money," said Kshitija.

“The risks we can take in our profession or life may not reflect when it comes to taking risk on money," she added.

Breaking ground

What happens if you and your spouse plan finances jointly? Lovaii Navlakhi, a Bengaluru-based financial planner says that his firm International Money Matters Pvt. Ltd makes both spouses take the test. “Many times they end up with varying risk profiles. For instance, the wife turns out be very conservative and husband turns has an aggressive risk profile. So, we try and construct a portfolio that falls somewhere in the middle," Navlakhi said.

One challenge that many financial planners face is when their clients show a low risk tolerance and a high risk capacity. One approach is to accept it and allow the investor to continue with a low equity exposure. The other, they say, is to slowly nudge the investor to increase her equity exposure and thereby her risk tolerance. “When couples come to me, women are mostly risk averse. While we construct a portfolio that best represents the couple’s needs jointly, we also explain to the women the implications of avoiding risk, especially if they have long-term goals that require an equity exposure," said Steven Fernandes, a Mumbai-based Sebi-registered investment adviser.

Rohit Shah, who is also a Sebi-registered investment adviser, as well as the founder and chief executive officer of Mumbai-based financial planning firm Getting You Rich, says that investors need to be given time for evolving. Those with a low risk tolerance need to be introduced to equities slowly, even if their capacity to take risks might be high.

“Once this investor gets a good experience from equity MFs, then slowly the tolerance will change and she can increase her equity investments, slowly and gradually," he said.

What should you do?

You think you know yourself well, but you could be wrong. So, go ahead, take the test and don’t baulk at the number of questions you need to answer in a risk profile test. It pays to know the unknown now, to avoid nasty surprised later.

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