Investors Risk Profile

By April 1, 2015 Blog

Mr. Gerard Colaco : We do not believe in risk profiling as it is commonly understood. This, in our opinion is a thoroughly useless activity. There is no way a client who is a unique individual with a unique personality, psyche and attitude can be accurately assessed for risk appetite by answering a few dumb questions in a risk profile questionnaire. Curiously, the NISM-Series-V-A work book for Mutual Fund Distributors’ Certification Examination has this to say on page 210 of its September 2012 version:

“12.1.3 Risk Profiling Tools

Some AMCs and securities research houses provide risk profiling tools in their website. Some banks and other distributors have proprietary risk profilers. These typically revolve around investors answering a few questions, based on which the risk appetite score gets generated.

Some of these risk profile surveys suffer from the investor trying to “guess” the right answer, when in fact there is no right answer. Risk profiling is a tool that can help the investor; it loses meaning if the investor is not truthful in his answers.

Some advanced risk profilers are built on the responses to different scenarios that are presented before the investor. Service providers can assess risk profile based on actual transaction record of their regular clients.

While such tools are useful pointers, it is important to understand the robustness of such tools before using them in the practical world. Some of the tools featured in websites have their limitations. The financial planner needs to use them judiciously.”

The author of the NISM workbook is of course sounding a polite word of caution. On the other hand, many leading investment writers show ill-concealed contempt for such concepts as risk profiling. We quote from the book “Smarter Investing” by British author Tim Hale, who states in the foreword of the second (2009) edition of his book:

“More often than not the risk we need to take (risk required) is more than we could afford to take (risk capacity) and more than we normally prefer to take (risk tolerance). Which is the dominant one for you? What is the right mix? Many individuals would prefer to say this is just too hard. But you and your family will live the outcomes of these decisions and they must be made based on your values not someone else’s. It’s just not fair to your family to leave it to someone else to decide.

Worst of all do not leave it to a common risk profiler or portfolio picker. These are usually idiot quizzes offered by lazy life companies, indolent fund managers and apathetic financial advisers. More akin to the more lurid women’s magazines and astrology predictions than science, they seek to box unsuspecting investors into such groupings as ‘You are a balanced investor seeking inflation protection, tax efficiency and regular income’ from the answers to half a dozen unrelated questions. They might just as easily say ‘You are an Aquarian. You like new floats, holidays by the sea and highly liquid investments’.”

Let us now give you our version of risk profiling which we have used in our 28-year career in financial services, without a problem. We believe that you cannot fit any investor into a risk profile. We have seen people who are extremely courageous in their personal lives, including armed forces personnel, who will panic at the first manifestation of financial risk. We have also seen people whom we have observed to be timid and finicky in normal life situations, but have displayed a surprising ability to cope with investment risk.

We believe there are two types of risk. The first is a risk to capital. If an investment of Rs 10 lakhs falls to Rs 9.5 lakhs, it is a risk to capital. The second type of risk is a risk to return. Let us assume that an investment of Rs 10 lakhs in a highly conservative mutual fund systematic transfer plan strategy from debt and equity grows from Rs 10 lakhs to Rs 10.40 lakhs in a year when the stock market is bad. In the same year, let us assume that a cumulative fixed deposit would have grown from Rs 10 lakhs to Rs 10.9 lakhs. We consider the lesser return on the mutual fund STP strategy to be a risk to return.

Our experience is that while a few investors may grumble about low returns in the short run, no one panics and exits an investment strategy simply because of a risk to return. On the other hand, we have seen people who boldly proclaim that a 50% hit to their equity portfolio will not scare them, become totally panic-stricken when their portfolio diminishes by not 50%, but 5%. We cannot fault them. They stated that a 50% decrease in the value of their portfolio would not frighten them. They never stated that a 5% decrease would not terrify them!

Such investors and such investment behaviour cannot be predicted in advance. Investors are human beings and suffer from all behavioural quirks human beings are susceptible to. They are guided by emotions, impulses, instincts, prejudices, wishful thinking, hopes, fears, desires, almost everything, except logic and reason. What people exhibit when they seek your advice is their attitude towards risk, which is utterly inaccurate, irrelevant and therefore unimportant. It is only when risk occurs that an investor as well as an investment adviser will know the true ability of the client to take risk. Finally, life experiences and ageing can change risk capacity, something that no risk profiler can predict or provide for.

So the only reliable risk profiler is risk itself. Not some questionnaire. Furthermore, investors have an almost universal tendency to try and game risk profiling exercises. But when risk actually occurs, all gaming ceases and true behaviour is revealed. As Warren Buffet put it so beautifully, albeit in a different context; “It is only when the tide goes out that you know who’s been swimming naked.”

There are a category of investors who come to our office when the index is, say 50% below its last peak, in other words when there is a frightfully bad crash in the stock market. At this point, researchers, financial journalists and other “experts” will be busy predicting the death of equity investment and the very financial system. Now these investors, without any advice from us, place orders for purchasing stocks and / or make lump sum investments in diversified equity mutual funds. When we see such investors, we note that they are genuinely capable of taking risk and exploiting risk to their advantage.

As J P Morgan very presciently observed almost a century ago, “Bear markets are when stocks are restored to their rightful owners.” We do not advise such investors because they do not need advice. Their true ability to take risk is now revealed, known and proved.

All other investors are assumed by us to be risk-averse. To these investors we recommend starting with any one of the following two strategies where a risk to capital would be virtually non-existent. The first strategy is to invest their lump sum in a liquid fund or a short-term floating rate fund or a short-term fund and then register a monthly capital appreciation transfer to an equity index fund or a well-diversified equity fund.

The second strategy, which has repeatedly proved that it does not cause a risk to capital is where you invest a lump sum in a liquid fund or a short-term floating rate fund or a short-term fund and then register one or more systematic transfer plans to an equity index fund or well-diversified equity fund to the extent of 1% of the initial corpus per month. For example if Rs 10 lakhs is invested in one of the debt funds indicated above, Rs 10,000/- per month would be transferred to equity.

In the latter strategy, we advise the client to double the STP if the stock markets fall by 25% from their previous peak and remain below that level for at least a month. And if the stock markets fall by 50% or more from their previous peak, then we advise either quadrupling the original STP or – better still – shifting the entire amount that is in the debt funds, to equity funds, at one go, in both the above options. This is in line with Warren Buffet’s dictum: “The first rule of investing is, do not lose. And the second rule is, do not forget the first rule. And that’s all the rules there are”.

Finally, for clients whose risk taking ability has been proved to a moderate extent, and who have regular income flows such as salaries and rent, we suggest long-term SIPs into index funds, diversified equity funds, balanced funds and / or asset allocation funds.

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