Mutual Fund Awareness 108: Psychology of Risk Profiling
Risk Profiling: Is a behavioral finance concept that tries to understand the ability of an investor to digest risks. We all do risk profiling daily, but we are not conscious of it. When you assess the payoff of a particular job against the risks that are associated with it, you are doing risk profiling.
Before attempting a job, we do these risk:payoff calculations in our mind and commit only if the payoffs are worth our efforts. If the payoffs are not worth it, you might not even take up that job, but the moment the payoff is higher than your psychologically accepted level, you’d be willing to do that job.
For example, imagine you are currently earning a Rs25000 salary working as a cashier in your hometown. You might not be willing to relocate to another state 1000km away, even if the salary is Rs35000. If the salary increases to Rs60000, you may be slightly willing, but if the salary is Rs80000 or above, you might commit.
The reason you did not agree to a 35000 salary was that the efforts for relocation were not worth it. The moment it went above a threshold of 60000 or higher, your psychological calculator assessed the cost of relocation, travel, and stay, and felt it would offset all of these.
Investing is no different. If the issuer increases the payoff, you would be ready to assume more risk. This is why lower credit rating instruments often collect a substantial amount from investors. This is why investors deposit money in local societies that offer a yield of 12% or more, compared to nationalized banks with fixed deposit rates of 6%. Tomorrow, if a private player launches a debenture at 14% or 16% interest, these investors may even borrow at 10% and invest.
History books are filled with stories of how thousands of investors have lost their life savings by investing in high-return instruments, often due to a false interpretation of the high risk. Not only did they lose their monthly interest income, but they also lost the original capital.
Risk profiling falls under behavioral finance and psychology because the human mind may not fully comprehend the payoff diagram of risk versus returns. This is because the investor assumes the risk-reward payoff to be linear, like a perfect 45-degree line chart.
They are unaware that in reality, the risk:reward is not perfectly elastic and after a while the risks increase faster than a proportional rise in reward.
Some general factors decide our risk-taking ability.
- Age — A person with a lower age can assume a higher risk, because if they end up losing money now, they have ample time to recover.
- Source of Earnings — Having multiple sources of income improves your risk profile, as you always have a backup if one of your income sources stops.
- Dependents — the lower the count of dependents, the riskier bets you can take.
- Wealth — if you already have a capital base, you can flex your risk muscles a bit more.
- Insurance cover — If your human life value is covered with adequate insurance, you might feel safer to assume higher risks in new investments.
- Regularity of Income — A person with a defined and regular income can take calculated risks.
- Financial Literacy — A person with a higher knowledge level can assume a higher risk.
The standard method of collecting these inputs is via intuitive questionnaires (sometimes, the investment advisor may have to ask the same question disguised in different tones to get a better score). Another point to understand is that these seven factors could change with time, and when they change, a new data collection is mandated.
Since there are more than seven data points, and each of them has an additional 5 to 6 sub-sections, the permutations and combinations of the data collected could be nearly infinite. Hence, it is rare to find two people with precisely the same responses. This puts additional responsibility on the investment advisor to offer you a customized solution based on your choices.
The role of an investment advisor is not just to suggest the best asset allocation, but to stop the investor from making insane investment decisions. Investors may prefer to subscribe for the high-risk 16% yield debenture, but the investment advisor has to instill a sense of calm and wisdom. He should be able to convince the investor to avoid these instruments that could wipe out the capital.
Most scammy financial products come with an “urgency” time tag. These people will ask you to make the decision right now, as the offer could expire if delayed. At the heat of the moment, the investor might be inclined to go ahead with the deal, but the investment advisor could review the proposal objectively and suggest whether that product is a good fit for you or not.
The investment advisor is like a cricket coach who teaches the batter not just the balls to play, but also the balls to defend or leave alone. A batter who defends or leaves a high-risk ball ends up preserving their wicket, thereby staying in the game as long as it is required.
Risk profiling is more of an emotional quotient decision than an intelligence quotient one; hence, it has roots in psychology rather than just mathematics. You might be very skilled in your area of work, often a thought leader or innovator, but when it comes to investing, you may be swayed away by Ponzi schemes and frauds disguised as a high-return instrument. To determine if it’s good or bad, you should consult an investment advisor who can also assess its risk element.
For your benefit, I have created a sample of a risk profiling Google form — click here. It has around 20 plus questions, making it comprehensive as well as intuitive. Once I assess the data people submit, I get a fair idea of their appetite to take risks. Usually, I play back what I have learned with the client to ensure we’re on the same page.
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