Are Indian advisors taking to this innovation?

In our previous article (Click Here), we looked at the multidimensional approach to risk profiling that advisors should use to build a client's risk profile. What are some of the practical limitations? What are questions that advisors should be asking but perhaps fail to? Why are risk profiles not up to the mark?

“Too often, in our experience, advisors focus on the regulatory aspects around risk appetite and treat it as a “ got to do it, so will do it” rather than a pre sales process that can add very powerful insights on likely investor behaviour in the future,” said Vishal Dhawan from Plan Ahead Financial Solutions in Mumbai.risk tolerance and investment experience. Scoring was at times rudimentary and arbitrary. The scores were then mapped to a set of asset allocations/model portfolios. So a score of 17 out of 20 may indicate an aggressive investor whereas a score of 14 may indicate a moderate investor. This approach still forms the basis for most risk profiling questionnaires.

In the next stage of questionnaires, advisors started to move towards complex questions to assess asset allocation/model portfolio and determine if expected returns were projected against goals. While projection techniques could be still rudimentary, advisors were able to broadly recognize that risk tolerance could be a constraint on what might be recommended.

Questionnaires took a huge leap in the next stage when science was introduced into the risk tolerance assessment process with the use of psychometric testing. By building a psychological profile, advisors could then further use modeling software to determine the products where the client's needs would fit better. With advances in technology, risk capacity and bench marking are now evaluated separately in many modeling software solutions.

Without fancy technological tools, can advisors accurately build an accurate risk profile? Dilshad Billimoria of Dilzer Consultants in Bangalore recommends advisors should “try to observe the attitude of the investor in formulating a risk objective. The investor’s stated willingness to take risk is often very different across individual investors and across time horizons. A Financial Planner should try to understand risk tolerance – the behavioural and personality factors behind an investor’s willingness to take risk. Even if an investor is eager to bear risk, practical or financial limitations often limit the amount of risk that can be prudently assumed. This is where risk capacity comes in.”

The ignored piece of the puzzle

International studies indicate that risk capacity is something that is often ignored on questionnaires. As risk capacity varies over personal circumstances, advisors should look be asking investors these kind of simple questions:

• Do you have a specific goal in mind like a daughter's wedding or education?
• How long are you planning to invest for?
• How much can you afford to lose?
• How quickly would you need access to the investment?

To evaluate a client's risk capacity, advisors need to consider the investor's spending needs, long-term wealth targets, liabilities, and the investor’s financial strength.

• In terms of spending needs, how much volatility would inconvenience an investor who depends on investments Or, how much volatility would inconvenience an investor who otherwise cannot afford to incur substantial short-term losses? Investors with high levels of wealth relative to probable worst-case short-term loss scenarios can take more risk.
• In terms of long-term wealth targets or obligations, how much volatility might prevent the investor from reaching these goals? Investors with high levels of wealth relative to long-term wealth targets or obligations can take more risk.
• What are the investor’s liabilities? An institution may face legally promised future payments to beneficiaries (creditors) and an individual may face future retirement spending needs.
• What is the investor’s financial strength—that is, the ability to increase the savings/contribution level if the portfolio cannot support the planned spending? More financial strength means more risk can be taken.

Evidence also suggests that the greater knowledge and experience possessed by client, the more amenable they are to higher levels of risk. Advisors need to evaluate if their questions adequately express what the client knows. Some of these simple questions may address this gap:

• Which investment types do you feel you can explain to a friend?
• Which have you held previously?
• Which do you currently hold?

Theory vs real world

investors to agree to a higher risk tolerance/risk appetite if the numbers suggest that there is a higher risk requirement and they do have higher risk capacity?

Proper communication and financial literacy of concepts are key in managing investor behaviour. “When there is a mismatch between the investor’s willingness and that investor’s ability to take risk, determining risk tolerance requires educating the client on the dangers of excess risk taking or of ignoring inflation risk, or living too long risk as the case may be. In our presentation, we educate the client about any risk Capacity and Willingness mis-match and that we are providing an appropriate risk objective in the IPS proposed to the client,” shared Dilshad Billimoria.

Data is also very important when it comes to convincing clients. “We believe that investors are constantly seeking data to support a particular hypothesis, and showing them the data around risk requirement and risk capacity for their specific objective is critical. For this, a complete wealth view, an ability to share the data in a format that is easily understandable and explainable, and a process of informed consent wherein the client chooses what needs to be done rather than the he advisor deciding what should be done is critical for this process to be successful,” Vishal Dhawan said from his experiences.

Managing investors

If the advisor encourages a higher risk profile than what the risk appetite alone suggests, is there a professional risk? How can one mitigate this risk? “The client should be fully aware of the shortfalls of having a higher risk tolerance (in case markets are high) against his readiness or ability to take risk and withstand a market crash,” said Dilshad Billimoria. Along with transparent communication, written approval from the client documenting the conversation helps not only protect the advisor from risk but also advances professionalism.

Ultimately, a multi-dimensional approach to risk profiling is not just about finding the relevant products for the investor, it is also about managing investor behaviour. When investors have a clear understanding what really are the trade offs that they are making on their investment portfolio construction decisions and there are conversations on an ongoing basis on all these dimensions, investors have increased confidence in their advisors. This helps advisors to better manage investor behaviour during periods of volatility.

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