Is this innovation relevant to Indian IFAs?
Product suitability - the process of recommending investments that are suitable to the individual investor - is the bedrock of financial products intermediation, whether you call it distribution, advice or wealth management. The most widely used tool to assess product suitability is a risk profiling questionnaire. Some say it is also the most abused tool, as it has often been found woefully inadequate in ascertaining product suitability. This inadequacy has spurred a lot more global thinking and insight into how to make the process of risk profiling more meaningful, more relevant – and the outcome is an innovation called multi-dimensional approach to risk profiling.
What are the inadequacies of a standard risk profiling questionnaire and what can you do to make your risk profiler a valuable input in guiding your clients?
A typical questionnaire covers questions regarding age, stage of life, knowledge and experience of investments, time horizon of investment, purpose of portfolio, level of comfort with fluctuations. Based on the answers, the client is rated as a conservative investor, balanced investor, growth investor or an aggressive investor. Investments made on the basis of such a profiling exercise have often found to be sub-optimal, leading to a poor investor experience.
Many advisors miss key aspects that would help them better define a more comprehensive risk profile of their clients. What's missing in this conventional approach is that it is uni-dimensional - it assesses only one aspect which is the risk appetite of the investor. Modern day risk profiling has moved from a uni-dimensional approach to a multidimensional approach.
Welcome to the new age of multi-dimensional risk profiling
The new approach to risk profiling contains the following:
Risk appetite: Risk appetite is not a reflection of markets or financial circumstances but a psychological attitude towards risk. It differs from one individual to another and is a reflection of both personality and life experiences and it is largely settled by early adulthood.
The appetite for risk is not the same across all spheres of a person's life. An adventurous person, who loves mountain climbing and traveling to exotic locations, may not like to take huge financial risks. Conversely, someone who lives a very modest lifestyle may be willing to gamble on higher-risk investments.
Risk appetite is linked to expected returns – how much risk will an investor actively pursue to achieve the reward they seek? Is the investor willing to take greater risk investments in order to get the possibility of higher returns or is the priority to reduce the likelihood that one will get back less than invested?
Risk tolerance: The terms risk appetite and risk tolerance are frequently used interchangeably, however, they represent related, but different concepts. Risk tolerance refers to the investor’s psychological ability to cope with the volatility of capital markets.
How will they respond to market corrections? Will they get nervous or will they stay the investment course? Risk tolerance is essentially the emotional capacity to withstand losses without panicking.
While risk tolerance does decrease slowly over time and may be changed by life events like marriage and having children, it is mostly stable even through financial market highs and lows. So while risk appetite sets the tone for taking risk, risk tolerance sets the threshold and boundaries for acceptable risk taking.
Risk capacity: The level of financial risk that an investor can take on comfortably based on their current life situation. For example, a young, single investor can afford to take on more risk whereas a middle aged man with two children close to going to college may not have the capacity to do so even if he would like to.
Therefore, it is important to note that it is not uncommon for an investor to have an attitude to risk that is very different from their capacity to take it on.
Risk requirement: Based on the investor's financial goals and current resources, identifying the risks they may be required to take in order to achieve certain goals is key. Do they have children they want to send abroad for higher education? Do they need to plan for retirement? Are they looking to buy a house? Based on these goals, do they need to be more aggressive in their investments or more cautious?
What many advisors miss out in the traditional approach
To understand where many advisors go wrong, take a look at some of the findings from international studies which show the gaps in many risk profiles. While risk appetite is where most conventional questionnaires focus, international studies indicate that risk capacity is often poorly covered in questionnaires. Here are some of the salient findings of various studies done in different markets on the gaps studies have pointed out. :
How practical is the new approach in Indian circumstances?
Clearly, a multi-dimensional approach to risk profiling helps advisors and distributors get a much better understanding of the investor, which in turn can help you recommend products that are genuinely suitable to your investor. How practical however is it to expect Indian investors to engage meaningfully in this process? Does this innovation in risk profiling have merits in the Indian context? In the next article, we bring you insights from leading Indian practitioners on the relevance of a multi-dimensional approach to risk profiling.
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