Risk Profiling

  1. Different mutual fund schemes have different levels of risk. Different investors also have different capacity to take risks.
  2. 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.
  3. Hence, the process of identifying investor’s risks appetite is called Risk Profiling.
  4. The factors and their respective influence/impact on the investor’s risk profile is given in following table:
FactorsInfluence
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
  1. So, it can be said that a well-qualified married person with a steady job and an earning spouse will have the largest risk appetite.
  2. 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.
  3. The robustness level of these different tools on the internet is different.
  4. Some tools require investor to guess the answer which is not a correct approach.
  5. Moreover, investor might not be truthful in his answers.
  6. Because of the above reasons, risk profiling tools are still not an alternative to a good financial planner.
  7. However, it will not be correct to say that risk profiling tools should not be used since they may be misleading or may reduce investor’s confidence.

Asset Allocation

  1. There are various asset classes. equity, debt, gold, real estate. Sometimes, one asset class performs better, while the other performs poorly. This is because the factors affecting the performance of all the asset classes are different.
  2. Allocating an investor’s money between different asset classes is called asset allocation.
  3. The purpose of asset allocation is not to improve performance but to reduce risk.
  4. 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.

Strategic Asset Allocation

  1. Under strategic asset allocation, investor’s funds are allocated to different asset classes based on his risk profile.
  2. Funds are not allocated based on expected performance of asset classes.
  3. A simple thumb rule of this type of allocation is to have as much percentage of debt in the portfolio as the age of the investor.
  4. Since Debt is considered safer than equity, as the age increases, investor’s funds are moved to safer investment options.

Tactical Asset Allocation

  1. Tactical asset allocation involves timing the market and is therefore riskier and suitable only for seasoned investors who have a deeper understanding of the markets.
  2. 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 are allocated.
  3. Even experienced investors should limit the size of the portfolio where they allocate funds tactically.

Model Portfolio

  1. Model portfolios are developed by financial planners with some investment options for investors falling in different risk, age, earning capacity brackets.
  2. For example, a Young call Centre/ BPO employee with no dependents should have a portfolio like this:
Diversified Equity SchemesSector FundsGold ETFDiversified Debt FundsLiquid Funds
50%20%10%10%10%
 
  1. Similarly, Young married single income family with two school going children should have a portfolio like this:
Diversified Equity SchemesSector FundsGold ETFDiversified Debt FundsLiquid Funds
35%10%15%30%10%
  1. Further example could be of a single income family with grown up children who have not settled down is likely to have a portfolio like this:
Diversified Equity SchemesIndex FundsGold ETFDiversified Debt FundsLiquid Funds
35%10%15%30%10%
  1. In another example, a couple in their seventies, with no family support should have a portfolio like this:
Diversified Equity Index SchemesMonthly Income Plan (MIP)Gold ETFDiversified Debt FundsLiquid Funds
15%30%10%30%15%
 
  1. Hence, we cannot say that a couple in seventies should invest in only debt mutual funds and not equity.
  2. Hence, we can say that for a couple in seventies who has never invested in equity and now wishes to start a SIP of a small amount in equity, the planner should suggest a Diversified Equity Fund.

Behavioral Bias in Investment Decision Making

  1. The investment decision making must be done by analyzing expected performance of the investment and the risk associated with the investment.
  2. However, investor often takes his decision not by careful analysis of relevant information, but based on his behavioral bias like confidence bias, herd mentality and choice paralysis etc.
  3. In Optimism/ Confidence Bias, Investors acquire confidence and believe they can continuously outperform the market based only on some success.
  4. In Familiarity Bias, Investors invest only in those stocks and sectors with which they are familiar and have more information.
  5. In Anchoring bias, Investors continue to rely on old information which is no longer relevant for decision making. They dismiss the new information as irrelevant.
  6. In 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.
  7. Further, in Loss Aversion, 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.
  8. Herd Mentality is a bias where 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.
  9. Recency Bias is where investors take recent events and extrapolate them to predict future.
  10. In Recency bias, 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.
  11. Choice Paralysis bias is 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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