Measure your risk ability, then invest

Making the right investment choices is never easy. Ascertaining your risk appetite rightly should help. The market regulator, Securities and Exchange Board of India (Sebi) agrees.

If the recommendations from its concept paper on 'Regulation of investment advisors' is implemented, investment advisors will have to create risk profiles of their clients before dispensing suitable investment advice. However, not all advisors seem excited about the prospect. Should investors, then, take the exercise seriously?

Risk profiling, based on a set of queries answered by the client, is already practiced by most advisors (see box on queries). The client's response to possible investment scenarios and their return helps gauge risk perception.

This, when considered with respect to one's age, current and anticipated assets, liabilities and goals helps determine the investor he or she is (aggressive, balanced, cautious). This, in turn, determines the ideal asset allocation for the person.

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For instance, Assam-based businessman Binod Somani, 36, has an investment horizon of 12 years before needing funds for his daughter's education. His risk profile showed him to be a 'cautious investor' and, yet, he wants returns that will beat inflation.

As a first-time mutual fund investor, his financial planner asked him to invest in large-cap equity diversified funds. Though one-year returns from such funds have been negative, the longer term (five years) return has been 4.79 per cent.

Detractors of risk profiling say there is a difference between the person's risk perception and his actual risk-taking ability. Unless the planner bridges that gap, he won't be doing justice to the client.

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For instance, take Arvind Trivedi, 25, profiled as 'very aggressive'. Trivedi has no dependents and believes he should be investing heavily into the equity markets. However, his actual risk taking ability is much lower, since he plans to settle down in the next three years.

His financial planner has asked him to limit his direct equity investments to 10-15 per cent of monthly income while investing in mid and small-cap and multi-cap funds. Three-year average returns on these were 28.64 and 24.93 per cent.

Suresh Sadagopan, founder, Ladder7 Financial Advisories, says: "A person's risk perception may vary depending on external factors like market conditions or even the way the questions are framed."

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He cites clients who reply in the negative to the query, 'Would you mind if your investment fell from Rs 1 lakh to Rs 80,000 in a year, but could grow to Rs.1.65 lakh after six years?'

However, the same client doesn't mind the slow pace at which his investment will grow and answers in the affirmative when the question is worded differently, 'Would you mind if your investment grew by 65 per cent in six years?', not realising both questions mean the same.

Similarly, those tracking behavioural tendencies of investors say, typically, the latter take more risk during a bull run and get risk-averse during a bear run.

"This is exactly the opposite of how it should ideally be. So, a client's answers may be based on either greed or fear, even if the financial planner is asking rational questions," says Parag Parikh, chairman, Parag Parikh Financial Advisory Services.

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Some thumb rules include allocating higher equity investments for younger investors and shifting to debt instruments a few years prior to one's goals. But, with each client having his own sets of views and complexities, the rules need tweakingd, feels Ranjeet Mudholkar, vice-chairman, Financial Planning Standards Board India.

He advises classifying goals into short-term, medium-term and long-term to get the right investment tips. "Goal-based financial planning would consider the impact of traditional parameters like age, income, dependents on achieving these goals and the risk profile one would see if the client has mitigated his risks related to these goals."

Investors are also advised to self-assess their risk perceptions periodically.

Every change in risk perception may not necessarily warrant a change in portfolio. However, seeking professional help may help allay fears that could otherwise result in impulsive investment decisions.