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When the markets are going up and up, everyone goes on the bandwagon irrespective of adequate understanding of financial goals, risk appetite and investment objectives. However, when the markets turn around and head downward, the investors are in for a rude awakening. Even the most daring of the investors realize that their risk appetite is lower (and much lower in many cases) than what they perceived it to be.
The process of investments-making should not be started without determining the risk appetite or profile of an investor. There are two aspects about risk - Willingness to take Risk and Ability to take Risk. Whether someone is investing by herself or with the help of an advisor, a good understanding about both the risk aspects, aids in choosing more appropriate investment instruments. The chances of surprises become less and the investor is able to handle the market volatility without being unduly worried about it.
Willingness to take Risk
Willing to take Risk is primarily a function of individuals' emotional and behavioral biases. I have written about some of these biases in my previous article "Emotizing Your Investments". A simple question like "How would you learn to drive a car with options - Registering at a learning school, Parent's Car, Friend's Car, Second Hand Car and Buying a New Car" and the option chosen can tell about a person's propensity to take risk. A carefully designed risk profile questionnaire can provide valuable insights into whether a person is Aggressive, Moderate or Conservative in her outlook.
Ability to take Risk
Ability to take Risk is determined from a person's assets, liabilities, current income, expenses, remaining earning years, financial goals, liquidity requirements etc. For example, an individual with limited assets and near-future goal of son/daughter college education will have the ability to take risk most likely as Conservative. But, a C-level executive at the peak of her career with decent financial assets will have the ability to take risk as Aggressive.
Risk Profile Determination
When both Willingness and Ability to take Risk are determined, it is quite possible that the results are not in sync with each other. Willingness could be Moderate whereas Ability could be Aggressive. In such conflicting situations, if professional advisor is involved then the investor should be counseled so that the right risk profile is chosen. If there is no professional advisor involved then the investor should seek advice. In any case, the chosen risk profile should have the lower value so in case of a conflict between Moderate and Aggressive, the answer is Moderate. Over a period of time, the risk profile may become different depending upon changed circumstances, increasing investment experience and higher or lower confidence in markets. Once the risk profile is determined, the investor can proceed with investments selection accordingly. An Aggressive investor will tend to invest more in risky assets - stocks, mutual funds, alternate assets - as compared to a Conservative investor.
Mitraz Financial approach to Financial Advice includes determination of Willingness and Ability to take Risk and Overall Risk Profile. A financial and risk profile questionnaire is used to gather the investor-related data. Qualified and experienced advisors translate the data into insights that lead to customized Financial Planning. The asset allocation and investments are chosen strictly according to the risk profile. The resultant portfolio's performance, volatility due to market movements and downside risk are as per the investor's personal, financial and emotional situation.
The writer is the Managing Director of Mitraz Financial Services Pvt. Ltd and can be contacted at firstname.lastname@example.org