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A Useful Risk Profiling ‘Shortcut’

Ignoring the process of risk profiling can further worsen the effects of the optimism bias as well as its distant cousin – the loss aversion bias

Investment risk profiling is possibly the most critical (and unfortunately, the most ignored) step of the Financial Planning process. Whereas in principle, most people are aware that all investment vehicles are not suitable for everyone, only a handful of investors actually embark upon their investment journeys from the safe shores of risk profiling; preferring to be thrown into the deep end instead. This can have disastrous consequences.

Even detailed risk profiling questionnaires have come a cropper on many an occasion - for an interesting reason. Clients tend to become more optimistic when asset prices have already gone up, and veer towards pessimism when assets slip into bearish cycles. In other words, risk profiling scores are contingent upon the current state of the markets! This is known as the "optimism bias", and is one of the chief reasons why retail clients notoriously end up buying high and selling low, failing so often to learn from their own past mistakes.

Several factors combinedly determine one's individual risk profile (and subsequent ideal asset allocation). These include one's attitudes and beliefs towards risk taking; as well as more visible profile determinants such as their number of dependants, the size of their emergency corpus, stability of their job, savviness about investments, past experiences, and the like. Indeed, a thorough risk profiling questionnaire can comprise of anything from ten to fifty questions. Understandably, most clients unwisely choose to bypass the 'ordeal'.

Ignoring the process of risk profiling can further exacerbate the effects of the optimism bias, as well as it's distant cousin - the loss aversion bias. These tendencies, combined, ensure that investor money is exactly where it shouldn't be at a given point in time. In other words, when pessimism reigns supreme after asset prices have crashed, retail investors cling to low risk assets like magnets. When the tickers turn green and spirits begin to soar, they flit from risky to riskier assets like fireflies; effectively buying heavily into overpriced investments.

By ascertaining their ideal portfolio mix and following it up with a proper allocation between high risk and low risk assets, investors will be taking an important step towards protecting themselves against their own behavioural demons. Additionally, a dispassionate, periodic rebalancing to bring one's asset allocation back to their ideal one is also necessary.

If you're one of the large majority of people who would much rather not undertake a lengthy risk profiling questionnaire, here's a simple three-question quiz that can help you arrive at a "quick and dirty" estimate of your investment risk taking potential (assuming, of course, that you answer them honestly).

Question 1: Markets head south three months after you invest, and your portfolio unexpectedly falls by 25 per cent. What would you do? Sell your investment (1 point), do nothing & wait (2 points) or buy more (3 points).

Question 2: You're on a TV show and are presented with one of three options. Which one would you choose? Rs. 10,000 guaranteed (1 point), a 50 per cent chance of winning Rs. 1 lakh (2 points) or a 10 per cent chance of winning Rs. 10 lakh (3 points)

Question 3: What's your investment time horizon? Less than a year (1 point), one to three years (2 points), three to five years (3 points) or over five years (4 points).

How did you fare? If you scored 4 or below, you're very risk averse. Stick to short term debt funds or fixed deposits, and make your peace with low returns. If you're between 5 and 7, you're a moderate risk taker. A balanced allocation between risky and low risk assets will stand you in good stead, assuming you can hold on to the high-risk investments for at least five years. If you scored between 8 and 10, you can afford to invest 80 per cent to 90 per cent into high risk, high return assets. Mentally, you're nicely geared for the long term capital appreciation that the more volatile assets such as equities could provide.

End Note: this three-question risk profile is really just a shortcut, and a superior alternative to "not profiling your risk at all". For an optimal long-term investment experience, it is strongly advised to undertake a more detailed risk profiling questionnaire to map out your more specific investing nuances and structure a great portfolio thereafter. A qualified Financial Planner can help greatly.

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