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What’s your risk apetite? Understand it before creating an investment portfolio

The combination of an aggressive advisor and a conservative client can lead to bloodshed unless the advisor toils to effectively assess the risk profile of the client.

Published: September 22, 2016 11:24 AM
We talk about risk from the returns perspective. However, it is important that one knows one’s risk capacity and risk tolerance. One is the ability to take risk and the other is the willingness to take risk. Both work hand-in-hand. If you have the ability to take risk, but not the willingness to take it, volatility in prices will effect your investment behaviour, which can affect your investment process. (Source: Reuters) The combination of an aggressive advisor and a conservative client can lead to bloodshed unless the advisor toils to effectively assess the risk profile of the client. (Source: Reuters)

Vijayananda Prabhu is Investment Analyst (Chief Manager – Investment Advisory Services), Geojit BNP Paribas

Mr. Kristy, a millionaire businessman, harbours a basic trait of miserliness. This induces him to buy the cheapest vegetable in the market, month on month, or sometimes hide his favourite book at a different corners of the same bookstore to read it later so that no body finds it easily, enabling him to make use of his library fee to the best extent possible. In this case despite risk taking capacity, Mr Kristy’s thrifty attitude overshadows his willingness to take risk. The social status of an average investor like Mr Kristy fails to throw light on his willingness or capability to undertake risky investments. This presents a classic dilemma situation for all financial advisors in their day to day advisory profession. A thought provoking issue in this matter would be to see how an advisor assesses the risk profile of an investor and its impact on the recommendations he makes along with joint investment decisions of the client and advisor.

The Client-Advisor Matrix

risk-prfoile

In a country like India, majority financial advisors hail from the middle income group. They often exhibit a conservative attitude towards money. Advisors with more than 80% equity asset portfolios is a rare oddity. Their asset quality choice is dictated more by low risk tolerance levels and capacity rather than knowledge or professional judgment. And does it reflect in their recommendations? It can to some extent. Their basic conservative economic traits and the accountability of their recommendation holds them from prescribing a largely equity-based portfolio. The combination of a conservative advisor and an aggressive client is rather harmless for both but is not an overall win-win situation. The client will end up losing opportunity(s) of earning that extra alpha and the advisor will remain a low-risk amateur throughout his life. It is like an intelligent surgeon afraid of seeing blood.

But the combination of an aggressive advisor and a conservative client can lead to bloodshed unless the advisor toils to effectively assess the risk profile of the client. Hence the relevance of risk profiling exercise is most significant in this combination. If both possess the same status, the standard error in portfolio choice minimises. An advisor turns aggressive due to two reasons. First by nature or his own financial status and second, by virtue of his profession. Advisors belonging to the latter group opine that their role in the financial market is to educate investors regarding capital markets and advocate infusion of money into the economy for sustained economic growth. This optimistic attitude may be derived out of past market performance and/or self-growth motivation. The former group already forms a part of the ‘creamy’ layer and hence are carefree about future.

An aggressive advisor may assume the role of a motivator or advocate investing into a high-risk asset class. However, mere confidence will prove fatal and substantiation through relevant facts and figures will help in arriving at a well-rounded investment decision. In this case, a conflict of interest may stem for a conservative investor who cannot match his risk behaviour with the aggressive stance of the advisor.

How to bridge this hiatus?
Investment decision is an amalgamation of fruitful discussions and participatory debates between the advisor and the client, based on which a diligent risk profiling exercise should be undertaken. This profile should form the base of all subsequent financial decisions. It should be reviewed on regular intervals and after significant life events.

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