12.1  Risk Profiling

12.1.1  Why is risk profiling needed?

  • Different mutual fund schemes have different levels of risk. Different investors also have different capacity to take risks. Sometimes, the investors think they are comfort table with higher levels of risk than they should be.
  • Risk profiling is an exercise undertaken to understand the risk appetite of an investor so that he can be advised on which investment is suitable for him.

How to advise investor about investment options which are suitable for his risk profile?

The investment advice depends on –

  • Risk appetite of the investor, and
  • Risk level of investment option

12.1.2  What influences an investor’s risk profile?

Family Information
Earning MembersMore the number of earning members, greater the risk appetite
Dependent MembersMore the number of dependent members, less the risk appetite
Life ExpectancyLonger the life expectancy, more the risk appetite
Personal Information
AgeLower the age, more the risk appetite
EmployabilityBetter a person’s qualification and higher the job prospects, more the risk appetite
Nature of JobSteady job means high risk appetite
PsycheDaring and adventurous people have higher risk appetite
Financial Information
Capital BaseMore the capital base of the investor, higher the risk appetite
Regularity of IncomeRegular income means higher risk appetite

12.1.3 Risk Profiling Tools

What are risk profiling tools?

Risk profiling tools are types of software that generate risk appetite of the investor on the basis of his response to a series of questions. Many risk profiling tools are available on the internet on the websites of AMCs, banks, Distributors, etc.

What are the limitations of risk profiling tools?

  • There are many tools on internet with different levels of robustness.
  • Some tools require investor to guess the answer which is not a correct approach.
  • Investor might not be truthful in his answers.

12.2  Asset Allocation

12.2.1  The Role of Asset Allocation

There are various asset classes e.g. equity, debt, gold, real estate. Sometimes, one asset class performs better, while the other performs poorly. This because the performance of all the asset classes are not affected by the same factors.

Allocating an investor’s money between different asset classes is called asset allocation.

The purpose of asset allocation is not to improve performance but reduce risk. The risk of a portfolio can be reduced if the portfolio comprises of assets which are not affected by the same factors in the same way.

12.2.2  Asset Allocation Types

There are two types of asset allocation –

A.  Strategic Asset Allocation –

  • Under strategic asset allocation, investor’s funds are allocated to different asset classes based on his risk profilenot on expected performance of asset classes.
  • A simple thumb rule of this type of allocation is to have as much debt in the portfolio as the age of the investor. Debt is considered safer than equity. As the age increases, investor’s funds are moved to safer investment options.

B.  Tactical Asset Allocation –

  • Tactical asset allocation involves timing the market and is therefore riskier and suitable only for experienced investors who have a deeper understanding of the markets.
  • The investor or planner tries to forecast which asset class will give the best returns in the upcoming period and on this basis the funds of the investor are allocated.
  • Even experienced investors should limit the size of the portfolio where they allocate funds tactically.

12.3   Model Portfolio

Financial planners develop some portfolios of investment options for investors falling in different risk, age, earning capacity brackets. These are model portfolios.

Examples of Model Portfolios –

A.  Young call center/ BPO employee with no dependents

Diversified Equity SchemesSector FundsGold ETFDiversified Debt FundsLiquid Funds

B. Young married single income family with two school going children

Diversified Equity SchemesSector FundsGold ETFDiversified Debt FundsLiquid Funds

C.  Single income family with grown up children who have not settled down

Diversified Equity SchemesIndex FundsGold ETFDiversified Debt FundsLiquid Funds

D.  A couple in their seventies, with no family support

Diversified Equity Index SchemesMonthly Income Plan (MIP)Gold ETFDiversified Debt FundsLiquid Funds

12.4  Behavioural Bias in Investment Decision Making

An investor needs to make many decisions when it comes to investment, like –

  • which asset class to invest in
  • how to invest
  • timing entry and exit
  • reviewing and rebalancing portfolio

These decisions must be taken by analysing –

  • expected performance of the investment
  • risk associated with the investment

However, often what happens is that the investor takes his decision not by careful analysis of relevant information, but based on his behavioural bias like confidence bias, herd mentality, choice paralysis. These are discussed below - 

A.  Optimism/ Confidence Bias

  • Investors acquire confidence and believe they can continuously outperform the market based only on some success.

B.  Familiarity Bias

  • Investors invest only in those stocks and sectors with which they are familiar and have more information.

C.  Anchoring

  • Investors continue to rely on old information which is no longer relevant for decision making. They dismiss the new information as irrelevant. E.g. an investor waiting for the right price to sell, even when new information suggests otherwise.

D.  Loss Aversion

  • Fear of loss of money holds back a lot of potential investors.
  • Sometimes, an investor also continues to hold on stocks which are not expected to perform well in future, just so they don’t have to sell them for a loss in the present.
  • If investors feel that there is a possibility of loss in short-term then they prefer to do nothing, even if taking the risk might lead to gains in the future.

E.  Herd Mentality

  • Some investors believe that others have better information and tend to follow others’ investment decisions.
  • This leads to a lot of investors entering the market when it is already overheated and poised for correction. Herd mentality also leads to creation of bubble in the market.

F.  Recency Bias

  • People take recent events and extrapolate them to predict future.
  • If there was a crash in the market some time ago, people place their money in safe assets. If there was a bull market, people place their money in risky assets even when the sound investment advice is suggesting otherwise.

G.  Choice Paralysis

  • If there are too many investment options or too much information available, then the investor might feel overwhelmed and do nothing.

Quick Revision

[WATU 9]

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Categories: Education