Innate willingness to take risk

Offer two people the same bet and they will answer differently. That difference is what the workbook calls innate willingness to take risk.

The workbook makes one point very firmly about it. Willingness to take risk has more to do with the individual's psychology than with their financial circumstances. Some clients find the prospect of volatility and the chance of loss distressing to think about. Others are relaxed about it.

So willingness is not the same as capacity. A wealthy client can be terrified of a 10% fall. A client with very little can be quite happy to gamble.

Whether the risk actually gets taken depends on two further things: the resources a person has, and the need to take the risk. More resources, more chance the risk is taken. A more important payoff, more chance again.

That is why Regulation 16 asks an adviser to assess willingness and ability, not one of them.

The workbook's coin-toss experiment, with its own figures. A person pays Rs 1,00,000 for one chance to play. He calls heads or tails. If the coin falls his way he wins Rs 2,10,000.

The bet is statistically favourable. Yet the workbook records that few people agree to play, simply from fear of losing the Rs 1,00,000. Raise the prize to Rs 2,50,000 or Rs 3,00,000 and more people play. That is the experiment's whole finding: the net payoff needs to be much higher for some people than for others, and that gap is innate willingness.

Willingness is one input; risk appetite is the outcome. Table 18.1 lists the factors affecting risk appetite under three headings, and only one row is about psychology:

The psyche row says daring and adventurous people are better positioned mentally to accept the downsides that come with risk. Everything else in the table is circumstance.

How it is measured. The workbook sets out the chain: a client's financial risk tolerance — attitudes, values, motivations, preferences and experiences — is measured with a risk profile; the questionnaire helps establish the tolerance level; risk tolerance is the assumed level of risk the client is willing to accept; and questionnaires estimate both the ability and the willingness to take risks, converting the answers into a score that classifies the client. The workbook's own three grades are Conservative, Moderate and Aggressive.

And why the honest answer matters. Section 18.2 warns that surveys suffer from the investor trying to guess the right answer when there is no right answer, and that profiling loses meaning if the investor is not truthful. Willingness is the one input a client can most easily misreport.

Two clients walk into the same adviser's office in Kochi. Both are 38, both earn Rs 20,00,000 a year, both have one child and no loans, and both hold Rs 40,00,000 of investments. On resources and need they are identical.

The adviser runs the workbook's coin-toss question at Rs 1,00,000 stake for a Rs 2,10,000 prize.

Mr Menon's threshold is ten times Ms Nair's in expected-value terms, on identical finances.

What the adviser does with it. She does not hand Ms Nair an aggressive portfolio and Mr Menon a conservative one on this answer alone. Table 18.1 has nine other rows, and Regulation 16 requires an objective process that does not give undue weight to some factors and less to others. One coin-toss response is one row of evidence.

What she does not do. She does not tell Mr Menon that refusing a favourable bet is irrational. Under-stating his willingness would be a profiling error; over-riding it would be a suitability failure. The workbook's framing is that there is no right answer to a risk profiling question.

And the part resources decide. Suppose Mr Menon had a Rs 45,00,000 home loan instead of none. His willingness would be unchanged — it is psychological — but his ability to incur and absorb losses would drop sharply, and the portfolio would change for that reason instead.

Chapter 18 (Risk Profiling for Investors), section 18.1, opens the chapter with the coin-toss illustration and states that this indicates the innate willingness of a person to take a risk in order to get a payoff. Table 18.1 then lists the factors affecting risk appetite, and section 18.2 sets out Regulation 16, whose second limb requires a process to assess the client's innate willingness and ability to take risks including the ability to incur and absorb losses.

Expect the coin-toss arithmetic itself (the Rs 5,000 net expected gain), the statement that willingness is more about psychology than financial circumstances, and a discrimination question separating willingness from ability or capacity.

• Willingness is psychological; ability is financial. Regulation 16 asks for both, and a candidate who treats them as one concept loses the discriminating mark.
• The coin toss is a favourable bet and most people still decline it. The expected gain is Rs 5,000, not a loss. The refusal is the finding, not an error in the arithmetic.
• Raising the prize changes participation, not the coin. The workbook's point is that different people need different payoffs for the same risk.
• Whether the risk is actually taken depends on resources and need as well. Willingness alone does not decide the action — see resources and need to take risk.
• Only the psyche row of Table 18.1 is about willingness. Age, capital base, dependents, employability and the rest are circumstances feeding risk appetite.
• There is no right answer to a profiling question. A client trying to guess one destroys the exercise, which is why the workbook flags untruthful answers as the main weakness of website tools.
• Do not treat this as a synonym of risk tolerance or financial risk tolerance. Tolerance is the assumed level of risk the client will accept, measured by a questionnaire; innate willingness is one of the two things that questionnaire is trying to estimate.