22 October, 2011

Risk Assessment

It’s funny how people respond to the same question, at different points. When things are going fine and optimism is reigning on the altar, people are buoyant and respond positively. The same question in more challenging times, evoke a far more gloomy, sometime diametrically opposite response!

But, many do risk assessment of their clients relying on responses of clients to basic questionnaires containing hypothetical questions. If the answers are going to vary so much based on environmental factors, like we saw earlier, how can this questionnaire be relied as a good indicator of the risk bearing capacity of a client? An example of a typical question in such a questionnaire is –“ What will you choose- a safe instrument giving 9%pa returns year-on-year or another that can give you 12% returns pa over long-term, but the returns every year can vary significantly, including being negative in some years?”. If you had asked this in year 2007, most respondents would have chosen the second option. If you were to pose the same question in 2008 or even now, most would look towards the safety of fixed income instruments!

If the answers vary so much based on the environment, how reliable are they? Clients have long-term goals and those need to be met. In fact this is the most important objective of a financial plan. From that perspective, a certain amount of risk may have to be taken regarding the investments to be done, in the interest of good returns. One cannot just stay invested in debt instruments alone like FDs, NSCs, PPF etc., as they give low real returns. Hence, a client is well advised to invest in Equity assets as well.

Now, if the risk profile shows up the risk bearing capacity of the client as very low, should a planner compromise on the goals and stick to the risk profiler? We have seen that the risk profiler itself could throw up different risk perceptions at different times.

A doctor does not ask the patient which medicine he would have. He simply prescribes them to him and the patient is to have them. The relationship that a financial planner shares with a client is similar. It is for the financial planner to understand the client situation, suggest appropriate instruments to invest in. It is his duty to also make the client understand why he has suggested that asset allocation and what the merits and drawbacks of such an asset allocation strategy are. The client will still have to take the call; but what the financial planner is suggesting is not based on the responses obtained in a simple questionnaire.

This kind of a questionnaire is arguably useful to someone who is just advising clients on investments and does not have complete information of the client and an understanding of his situation. But even then the limitations mentioned earlier, would very much be there. To circumvent this, a questionnaire has to be scientifically validated for consistency of outcomes, over a large sample and has to be standardized. This can help to an extent. It still leaves the other problem – if one were to strictly go by the risk profile, goals may not be met. Hence, there is no alternative to an informed diagnosis and a judgement from a Financial planner on this.

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