Importance of Risk Profile in Financial Planning

Investment planning is all about managing the trade-off between risks and returns. But what is this risk? It is the uncertainty of the future outcomes with respect to the return expectations an investor has.

In the world of investing, the traditional assumption is that each investor is a rational and logical being. A rational being makes informed decisions based on logic and accordingly expects returns vis-à-vis the risk taken for portfolio investments. But in reality, we are all humans who are not completely rational and are prone to emotional responses. This makes it difficult for investors to determine how emotions will play out in future financial decisions taken by them.

In order that the investor selects suitable investments and develops a long-term investments plan, she needs to develop a proper understanding of her goals, investment time horizon, liquidity, and risk aversion. Even when an investor approaches a professional investment advisor or a financial planner, the first step for an advisor would be to know them. To know the client, besides undergoing financial health check-ups, and listing down her financial goals, she has to fill up a risk profile questionnaire. This is one of the critical and pre-requisite steps in the entire process since regulators also insist that financial advisors keep the investor’s risk profile at the heart of financial planning.

We are aware that all investments are subject to varying degrees of risks, and on the other side, every investor has an inherent threshold to bear those risks, which even she is also not aware of. Hence, risk profiling helps the investor know about how much risk she would be able to withstand in her investment journey. Based on this profile she can make an informed choice or a professional advisor can advise regarding suitable investments. 

Risk profile consists of two main components - one is the ability to take risks and the other is the willingness to take risks. When seeking guidance from professional advisors, the client has to fill up a questionnaire which is prepared meticulously with questions to gather certain factors that are measurable while some are psychometric in nature. A self-assessment by the investor can also be done if she is aware of all aspects of the risk profile.

The ability to take risks tells us about the risk capacity and it relates to the investor’s financial circumstances in context to achieving her financial goals. Risk capacity can be objectively measured by financial parameters like age, employment status, dependents, total wealth, income, net worth, and other financial ratios. So, investors having high net worth, strong personal balance sheets, have a strong financial position leading to higher risk capacity. However, investors with higher risk capacity do not necessarily mean they have a high-risk tolerance. The reason being, risk tolerance relates to the investor’s willingness to take risks which are highly subjective depending upon various non-financial parameters like previous experiences, the background of the investor, personal values, indicating behavioral aspects. These behavioral aspects are difficult to measure directly, though psychometric tests can help. To assess risk tolerance, questions are specifically prepared to know the investor’s behavioral aspects on investing, making losses in investing, volatility in returns, willingness to take greater risks for greater returns.  Due to these behavioral aspects, there is a lot of research and study being done and various models prepared in the subject of behavioral finance, which is the amalgamation of psychology and finance. Daniel Kahneman won the Nobel Prize in Economics for his notable work in applying psychology insights to economic theory, especially in the decision-making process under unknown and uncertain circumstances. 

Thus, for preparing an asset allocation for oneself, the investor has to understand the details related to risk capacity and risk tolerance as in a risk profile questionnaire, otherwise, the probability of the asset allocation being successful in meeting their objectives becomes considerably less. In the process, if the investor has the high-risk capacity and low-risk tolerance, then it will help her identify the grey areas like for an e.g., presence of certain biases and behaviours. On the other hand, if the risk tolerance is high but risk capacity is low, then building financial awareness could help. 

To summarise, investors can themselves, or with the help of an investment advisor prepare a viable and fruitful asset allocation aligned with their objectives and constraints with the help of a risk profile that takes consideration of all the above-mentioned aspects.

The author is an independent personal finance strategist 

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.