Why taking financial planning decisions based on your risk profile may be dangerous !
Risk profile is a notion mostly used in the field of investment. Financial analysts have propagated that you should invest your money as per your risk profile. But as an investor is it right to take investment decisions based on risk profile ?
Let’s first understand what is a risk profile.
Risk profile is an ability of an individual to take a risk on the invested capital.
Presently the risk profile is measured based on some questionnaires – this has been named Risk Profiler. Normally there are some parameters on which most risk profilers are designed. They are :
- Your age.
- Your income.
- Your family size.
- Your loan liabilities.
- What you feel about the financial market. Etc…….
Depending on the answers of these questions, points are awarded and then the individuals are categorized as : Aggressive investor, Conservative investor, Protective investor.
This categorization may change from planner to planner.
Now based on this categorisation, a pre-specified asset allocation is suggested, an example of which is below.
Aggressive: 80% equity + 20% Debt.
Conservative: 40 % equity + 60% Debt.
Protective: 20% equity + 80% Debt.
The investments products are suggested based on the above.
Does this questionnaire really reveal your risk profile? “My answer is NO.”
I am sure that most of the professionals working it the financial industry will not agree.
The answers of the individual who is opting for this questionnaire will keep on changing as per the situation on short term period as well, some points on same…………
- When markets are down, some individuals risk profile comes out to be Protective and during booming times when markets are at high, he may come out to be Aggressive. So it is based on the financial markets.
- The answers given are on the basis of the awareness of individual about the different aspects of financial management. If you give him proper knowledge his answers change keeping other factors same.
- The individual who comes out to be Protective may be very aggressive about risky asset class; the classic example is real estate investment. Individuals not comfortable with share market are very bullish on real estate investmentJ.
- Only age and earnings may not give clear idea about individuals risk profile, normally it is said that 100- your age = Equity exposure, which cannot be generalized as there are some other aspects also like short term goals, financial dependency etc.
- The result of risk profiling majorly speaks about the allocation in two asset classes: Equity and Debt. , So what about other asset classes like Cash, Real estate and Commodities?
- This system does not consider the risk due to inflation.
What are the major flaws in generalizing risk profile system based on Risk profiler?
Majorly it is seen that the person having good amount of money and good regular income , comes out to be aggressive so he/she keeps on taking higher risk , whether high risk may be needed or not. If he fails he may lose major part of his wealth.
A person having less amount of money and less regular income , comes out to be conservative or protective, so he/she does not take any risk even if it is required to ( That also he assumes but may end up not even beating inflation and therefore negative rate of return) and becomes more and more poor as time goes by.
So does risk profiling lead people to do mistakes?
I feel it is only a marketing tool to sell the products. What should you do then?
Your investment decisions should be based on the financial goals which you want to achieve in your life and not on risk profile.
A person having good amount of money and good regular income , having less goals and having enough money to fulfil financial goals as per the cash flows , should protect his existing wealth and future income so that he/she can achieve financial goals, So the stance may be Conservative or Protective depending on the wealth and should not be aggressive.
In the same way a person having less amount of money and less regular income , with high financial goals, has to setup first realistic goals and then have to take some calculated risk to achieve them. Even risk profiler would suggest to be protective.
Achieving your financial goals in life is a success of life.
Planning for financial goals is planning for holiday tour. While planning for holiday tour we first plan for destination then look for the availability of time with us and funding for same, after analysing these parameters we decide on the vehicle to travel.
In a same way depending on your financial goal (Destination), Years to goals ( Time available ) and investible funds (Affordability) we should choose the financial vehicle to reach the financial goal.
For same having a financial plan for self is of prime importance than having a risk profiler.