A Brief Overview on Risk profiling by Investment Advisors

Ashish M. Shaji

03 Jul, 2020

Assessing a client’s risk tolerance is essential to an investment advisor’s ability to add value to his or her relationship with the client. Without risks, one cannot expect rewards, especially in the modern market. Many people associated with the market have questions and are unaware of risk profiling by investment advisors.

What is Risk Profiling?

Risk profiling is a process of evaluating the optimum level of investment risk that a person is willing to take. It takes multiple factors into account to assess your risk.

It is a way of finding the level of investment risk considering the risk required, risk capacity and risk tolerance, where-

• Risk required is the risk associated with the return needed to achieve the goal of the client from the available financial resources;
• Risk capacity is the level of financial risk that a client can afford to take;
• Risk tolerance is the level of risk that can be tolerated by the client.

Risk profiling requires all of these characteristics to be assessed separately so that it can be compared with one another. It helps in knowing the kind of investor that you are, kind of returns that you can expect from your investment and the combination of investment that you should have.

There is a mismatch between risk required and the risk capacity, so the risk profiling helps in balancing the two. The investment advisor under SEBI plays the role of guiding the client through the trade-off decision that is necessary for arriving at an optimal solution.

What is the need for Risk profiling?

The main reason behind risk profiling by investment advisors is to determine asset allocation across different classes. However, for determining asset allocation, there is no rule. The market does not necessarily move in the same direction as it is very volatile and no one can predict where the market is heading with 100% accuracy thereby making it necessary to invest in market according to your risk-taking capacity, here is the need for a risk profiling. A person may want to take a high risk, but he may not be having the capacity to take the high risk. 

It is a common and best industry practice to conduct risk profiling, especially when giving personal advice. It is critical that both advisors, as well as the clients, understand the entire process of risk profiling and the implications of the advice and investments of the respective risk profiles.

It may be an unpleasant thing to know that you have suffered a considerable loss due to the underestimation of risk involved. Similarly, overestimation of risks involved can also be uncomfortable as it will cause you to miss opportunities. When making investments, it is essential to understand your reaction to different outcomes. Risk profiling is like a BP (Blood Pressure) check, to decide how fast can or should a person run on a treadmill, when to slow down and when to stop.

What does risk profiling cover?

Usually, risk profiling by investment advisors is done through a set of questionnaires covering many different factors.

It covers the following:

What does the SEBI circular contain regarding the risk profiling by Investment advisors?

The Securities and Exchange Board of India (SEBI) released a circular in December 2019 titled “Measures to strengthen the conduct of Investment Advisors”. It was released with an objective to strengthen the conduct of the Investment advisors and to protect the interests of the investors. The circular focused on proper risk profiling of clients by the investment advisors.

The SEBI noted that the Investment advisors are providing advice on a free trial basis without considering the client’s risk profile. It stated that investment advisors should not provide a free trial for any products or services to prospective clients. Further, it added that they should not accept part payments (where some part of the fee has been paid in advance) for any product or service.

The regulator stated that the investment advisors would only provide investment advice on completing the risk profile based on the information provided by them and must take consent of the client through registered e-mail or physical document.

Points to remember for risk profiling by investment advisors

Some of the essential points to know regarding risk profiling by investment advisors include the following:

• Without the knowledge about the investor’s objective, time horizon, investment constraints, liquidity needs and other factors, it is not possible to advise suitable investment to them.
• Every investment option is exposed to a natural risk, and it should match your risk appetite in order to have a proper risk allocation.
• Risk and return are related to each other positively, that means higher return requires a higher level of risk. Without a proper risk profile, one may underestimate or overestimate the risk, which may cause you to be unsatisfied with the return on your investment.
• Another essential point to know is that risk profile is not static; it changes over time depending on your life cycle, income, tenure of investment etc. Therefore your risk profile must be assessed periodically.

Conclusion