Home / Money / Personal-finance /  Why it’s important to ascertain risk appetite before investing

One of the most important aspects of financial planning is to know the risk appetite of an investor. We talk to financial planners to know why this is important and how do they work on this aspect.

Shyam Sekhar, Chief ideator and founder, iThought

We live in the era of ready-to-use. Most people think bespoke tailoring is old-fashioned. But ask a die-hard tailoring client and she will strongly vouch for its perfection. Success lies in measurement and tracking. It is the same story with investing.

Most of us just log on to apps and sites that ask a few perfunctory questions before recommending a product they want us to buy. We are even made to believe this truncated and hurried approach is planning.

But good, old-fashioned planning is far more holistic and at the heart of it is risk profiling of individuals. Understanding the risk appetite and risk taking attitude of a person is key to successful financial planning. Of course, as a financial planner you handhold your client into taking more risks depending on the recommended asset allocation, but no two clients of the same age will have the same asset allocation because the allocation gets defined by the comfort level of a client and this is important for the long term.

If the risk appetite and objectives are clearly established and every goal that matters is carefully constructed, the investment process has clarity.

Dilshad Billimoria, Director, Dilzer Consultants

Risk is the chance that an investment’s actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. An investor’s willingness to take risk is often different across individuals and time horizons. So, a financial planner’s job is to understand the behavioural and personality factors behind an investor’s willingness to take risk.

Any assessment of risk tolerance must consider an investor’s willingness and ability to take risk. It’s important to know both, because when a mismatch occurs between the two, it can disrupt the financial plan. When an investor’s willingness to accept risk exceeds the ability, a planner needs to place a limit and when the ability exceeds willingness, the planner must encourage as the investor may fall short of the return objective as willingness would be a limiting factor.

But it’s also about educating the client about market factors and dangers of taking excess risk; or, of ignoring inflation risk, or of the risk of living too long, as the case may be.

Priya Sunder, Director, PeakAlpha Investment Services

Asset allocation is the most important tool that financial planners use to help clients achieve goals. It determines the amount of risk your portfolio should have and forms the basis for implementing a financial plan. In arriving at the right asset allocation, a few things come together, such as goals, time horizon, and the client’s age. The risk tolerance of the client lies in the fringes when determining asset allocation.

It is important to maintain the right asset allocation without the risk tolerance of a client interfering or influencing this balance too much. We’ve seen people’s risk appetite change significantly over time. Risk is hugely discounted in a bull market and overvalued in a bear market. Financial planners play a big role in influencing that change by educating the client and helping him stay in line with his target asset allocation. The skill of a good planner lies in not merely acting as per the client’s wish, but in informing him what is the appropriate level of risk he should be taking and helping him stay on the right course.

Deepali Sen, Founder, Srujan Financial Advisors LLP

Analysing the risk appetite of a client is very important for a successful financial plan. Risk-taking ability, risk capacity or risk tolerance is a function of one’s need and, therefore, the time horizon of the impending goals.

The only exception I can think of is those (few) cases where the client is entirely closed to experiencing volatility even when the need is long term.

Asset allocation of a client is as much a function of one’s risk appetite as it is a function of age. For example, a young client who is the only earning member of the family, who has an ailing dad, homemaker mother, two younger sisters, one needing money for her higher education and the other one looking to get married, will have a different risk profile because most of his needs are short term. This client can’t afford to invest a huge chunk in the volatile or long-term asset class, namely equities.

Discounting risk and suggesting asset allocation based on the client’s age could lead to oversimplification and, therefore, be prone to errors. Also, it is contradictory to working towards customising the asset allocation to each and every client’s unique needs.

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