Foundation — What risk profiling measures, and the factors that affect risk appetite

Offer the workbook's game around a family dinner table. Stake Rs 1,00,000, win Rs 2,10,000 on a correct call.

The uncle who runs a transport business says yes at once. The schoolteacher says no. The software engineer thinks, then says "at Rs 2,50,000 I would." The grandmother says not at any amount.

Nobody in that room is wrong, and that is the point the chapter is making. The workbook observes that more people agree to play the game as the winning amount is increased to say Rs 2,50,000 or Rs 3,00,000, INDICATING THAT THE NET PAYOFF AMOUNT NEEDS TO BE MUCH HIGHER FOR SOME.

Notice also that the arithmetic is identical for all four of them. The expected value is Rs 5,000 — Rs 55,000 expected win less Rs 50,000 expected loss — whoever is sitting in the chair. What differs is the innate willingness of a person to take a risk in order to get a payoff, and the workbook is explicit that willingness to take risk has more to do with the individual's PSYCHOLOGY than with their FINANCIAL CIRCUMSTANCES.

This is why an adviser cannot derive a risk profile from a balance sheet. Two clients with the same Rs 40 lakh, the same age and the same goals may have completely different prices for the same coin — and the plan has to fit the person, not only the portfolio.

A man is asked to lend his car to a nephew for a long drive. Three separate things decide whether he does it.

Is he the kind of person who lends his car? Some people simply are; others find the thought unbearable. That is willingness, and it is about temperament.

Does he own a second car? If yes, the loan costs him nothing much. That is resources — and the workbook says more the available resources, more are the chances that the risk will be taken.

Does the nephew need it for a job interview or for a picnic? That is need, and the workbook says more important the payoff is for the person, higher are the chances that the risk will actually be taken.

All three appear in a portfolio decision. A cautious client with a small corpus and a distant, soft goal should probably not take equity risk. The same cautious client with an unavoidable retirement in eighteen years and no pension may have to — because the need to take the risk is a fact about the goal, not about her nerves.

This is the most practically useful distinction in the chapter. An adviser who reads only willingness will under-invest anxious clients into a guaranteed shortfall; one who reads only need will push frightened clients into positions they abandon at the first fall. The profile must carry all three, and where they conflict, the conflict itself must be discussed with the client.

Picture a roof resting on pillars. Add pillars and the roof is safer — one can crack without the house coming down. Put more people under the roof and the consequence of a collapse grows.

Table 18.1 states both halves as a matched pair. Risk appetite INCREASES as the number of EARNING members increases. Risk appetite DECREASES as the number of DEPENDENT members increases.

A household with three earners can absorb one of them losing work. A household with one earner and four dependants cannot — and it is not the earner alone who suffers the consequence.

The third family factor is the one students misread. Risk appetite is HIGHER when life expectancy is LONGER. It feels backwards — surely a longer life needs more safety? But a longer life is a longer horizon, and a longer horizon is exactly what allows a bad five years to be absorbed and recovered.

The practical version of this appears in Chapter 18's own model portfolios. A couple in their seventies with no immediate family support gets a conservative to moderate allocation with 15 per cent in a diversified equity index scheme. The same couple very sound physically and mentally, with a large investible corpus gets 25 per cent equity in total. Longer expected life, larger base — more risk, not less.

Two men, both aged 38, both earning Rs 20 lakh.

The first is a chartered accountant with a second qualification in data analytics, working at a firm that has had two rounds of layoffs. His job is shaky; he could be re-employed within weeks.

The second is a specialist machine operator at a stable, profitable plant with twenty years of orders on the books. His job is secure; if that plant ever closed, his particular skill would be hard to place elsewhere.

Table 18.1 treats these as two separate factors, and this pair shows why.

EMPLOYABILITY — well qualified and multi-skilled professionals can afford to take more risk. That describes the first man.

NATURE OF JOB — those with steady jobs are better positioned to take risk. That describes the second.

Neither man scores well on both, and an adviser who collapses the two into a single question about "job security" will misread one of them. The first has a fragile job and a portable career; the second has a secure job and a narrow one. Their capacity to sustain an equity drawdown while also losing income is genuinely different, and it differs in a way one question cannot capture.

The same care applies across Table 18.1 generally — it lists ten factors, not four or five, precisely because each one asks something the others do not.

A man visits his doctor, who asks how many cigarettes he smokes. He says four a day. The real figure is twelve.

He does not lie out of malice. He lies because he has decided there is a right answer, and he would like to be the kind of person who gives it.

The workbook names the identical failure in risk profiling: some of these risk profile surveys suffer from the investor trying to "GUESS" THE RIGHT ANSWER, WHEN IN FACT THERE IS NO RIGHT ANSWER.

And it states the consequence in one line: risk profiling is a tool that can help the investor; IT LOSES MEANING IF THE INVESTOR IS NOT TRUTHFUL IN HIS ANSWERS.

Why do investors do it? Usually because the questionnaire signals an answer. Words like "aggressive" and "conservative" carry approval and disapproval outside finance — one sounds decisive, the other sounds timid. A client who wants to appear capable in front of an adviser will drift upward.

The doctor's remedy is the adviser's remedy. Ask in a way that has no virtuous answer, ask in rupees rather than adjectives, and check the answer against behaviour — which is why the workbook notes that service providers can assess risk profile based on ACTUAL TRANSACTION RECORD of their regular clients. What a client did in the last fall is better evidence than what they say they would do in the next one.

The regulatory version says the same thing: questionnaires must be fair, clear and not misleading, must not be vague or use difficult or complex language, and should not contain LEADING QUESTIONS.

A small shop near a bus stand sells two things: umbrellas and ice cream. It looks like an odd combination until you watch it through a year. In the monsoon the umbrellas sell; in the summer the ice cream sells. The shop has a decent month every month, and it never has a brilliant one.

That is asset allocation, and the workbook's definition is precise: an EFFICIENT ASSET ALLOCATION is one that includes ASSET CLASSES THAT HAVE LOW OR NEGATIVE CORRELATION so that the returns from the investments do not rise and fall together.

Its own illustration is from real markets: during the recessionary situation in 2007-09, EQUITY MARKETS IN MANY COUNTRIES FARED POORLY, BUT GOLD PRICES WENT UP. Thus, an investor who had invested in BOTH gold and equity earned better returns than an investor who invested in ONLY equities.

Note what this is not. It is not a claim that gold is a good investment, or that it beats equity. It is a claim about direction — the two do not move together, and the portfolio that owns both has a smoother path than either alone.

The workbook adds the point that decides where an adviser should spend their effort: some international researches suggest that ASSET ALLOCATION AND INVESTMENT POLICY CAN BETTER EXPLAIN PORTFOLIO PERFORMANCE, AS COMPARED TO SELECTION OF SECURITIES WITHIN AN ASSET CLASS (STOCK SELECTION).

Most clients want to talk about which fund to buy. The research says the larger part of the answer was settled before that question was reached.

A family plans a drive from Nagpur to Goa.

The route they plan the night before, based on where they must reach and when, is STRATEGIC ASSET ALLOCATION — allocation ALIGNED TO THE FINANCIAL GOALS of the individual, considering the returns required, the time horizon available, and the risk profile. It is a LONG TERM PLAN that is reviewed periodically for continued relevance, and crucially, a change in these FUNDAMENTALS may alone trigger a change in the allocation.

Note what that excludes. The allocation to an asset class will NOT be increased on the basis of EXPECTED PERFORMANCE of the asset class. The road is not re-planned because a friend says the coastal route is pretty this week.

The detour taken mid-journey because the driver believes the highway will be blocked is TACTICAL ASSET ALLOCATION — the decision that comes out of CALLS ON THE LIKELY BEHAVIOUR OF THE MARKET. The workbook's example is going overweight on equities because of expectations of buoyancy in industry and share markets. And it warns sharply: tactical allocation is suitable ONLY FOR SEASONED INVESTORS OPERATING WITH LARGE INVESTIBLE SURPLUSES, who should set a LIMIT to the size of the portfolio on which they take such calls, with the major portion aligned to a STRATEGIC asset allocation.

The cruise control that adjusts speed by itself according to a pre-set rule is DYNAMIC ASSET ALLOCATION — it uses PRE-DEFINED MODELS to allocate assets, with triggers for re-allocation defined in terms of ASSET CLASS VALUATIONS OR PORTFOLIO PERFORMANCE. Its distinguishing virtue is stated in one line: dynamic asset allocation REMOVES THE SUBJECTIVE ELEMENT from asset allocation decisions.

Strategic is driven by the goal. Tactical is driven by a view. Dynamic is driven by a model. That triple is worth memorising as it stands.

A man has been painting the top of his house for eight years. He is nearly finished. This is not the moment to stand on the highest rung — not because the ladder has become less safe, but because he has nothing left to gain up there and everything to lose.

The workbook gives exactly this case. Jayant has been saving for the education of his children for the last 8 years by investing in equity. THE GOAL HAS TO BE MET AFTER 4 YEARS NOW. Jayant would NOT want to leave the funds that have been accumulated in equity any more, since there is a risk that the FLUCTUATION IN EQUITY VALUES WILL AFFECT THE AMOUNT THAT HE HAS ACCUMULATED SO FAR. Jayant would be ready to move the funds to LESS RISKIER INVESTMENTS at this stage.

Nothing about equity changed. The horizon changed — and the horizon is what made equity appropriate in the first place.

The workbook is careful about why rebalancing is done, and this is the examinable part: ideally, a portfolio should be rebalanced so that it is ALIGNED TO THE RISK AND RETURN REQUIREMENTS of the investor and REFLECTS ANY CHANGE IN THEIR NEEDS AND SITUATION, and NOT TO BENEFIT FROM SHORT-TERM MOVEMENTS IN ASSET PRICES.

Rebalancing is not a market call. A client who says "equity looks expensive, let us rebalance" has misunderstood the instrument — that is a tactical view wearing a rebalancing label.

And the review that precedes it asks four questions, all of them about the goal rather than the market: are all the goals still relevant; are the goals on target for achievement in the required time-frame; are the investments performing as expected; do the investments need to be changed if no longer suitable for the goal. The workbook sets the frequency plainly — at pre-fixed intervals, IDEALLY AT LEAST ONCE A YEAR.