Here are some issues of risk profiling tools -
- Some risk assessment questionnaires have poorly worded questions. The questions are unclear, complex or confusing. The user rather than admit that he did not understand gives an arbitrary answer.
- Some risk assessment tools do not have accurate scoring models resulting in wrong risk assessment.
- The risk tools that have many questions with 3 options or 5 options for answers are not effective as most people would go for the answer that is in neutral territory. This defeats the purpose of the tool.
- The descriptions for different levels of risk capacity and risk tolerance are sometimes poor and different people might interpret it in different ways.
- Usually it is used just once and the asset allocation is decided and it stays the same. But people and circumstances change. Therefore risk also has to be evaluated accordingly.
- Many times, risk is given a huge precedence over other aspects such as product risk, loan repayment or financial emergency. For example, if a person's risk profile is such that he can tolerate high risk and has the capacity but has a huge personal loan, it might make more sense to pay off the loan rather than invest in some high risk assets.
- Sometimes the whole risk assessment process is not treated with seriousness. Advisers do not research on the tool properly. They do not check its reliability, validity or consistency. People do not like answering these kind of questions and just go through it for the sake of it.
What should a good risk profiling tool do ?
- A good risk profiling tool should be able to capture the risk tolerance level and risk taking capacity, attitude to risk and risk required of the individual based on subjective and objective factors. The questions need to be probing and assess the psychology of the individual.
- The questions should be carefully worded. The answer options should be precise and simple so that users are not confused. If there are non-committal answer options, the user tends to select those. Those should be avoided as much as possible.
- Algorithm should be accurate and tested across different users and if possible multiple times. If many inconsistent results are found, it should be changed.
- The description of the results of the tool should be objective and easy to understand. If too many adjectives or judgemental words such as motivated, risk averse or risk taker are used, the investor might get influenced by them rather than the real risk parameters.
How can a risk profiling tool be used effectively?
- An effective risk profiling tool gives a fairly decent measure of the risk profile of a customer. But this cannot be treated as the only measure for determining the financial plan and the investment strategy. Financial knowledge, financial goals and the amount of risk that is required to be taken should be considered. The current financial situation of the individual has to be considered before making the financial plan. As the financial situation changes, so does the risk taking capacity. This means there might be a change required in the plan.
- The advisor or the individual himself should understand the limitations of the tool and list down points that are not taken care of or erroneously judged by the tool.
- The risk profile questionnaire is just one of the tools to plan investments investment plans. The answers given should be checked for consistency and accuracy. Many other factors are to be considered for a comprehensive financial plan.
- If a financial advisor is involved, they should discuss the financial goals, current financial scenario and returns expectations along with the risk profile to formulate a winning strategy.
- Common sense and current scenario have to be considered. If the client has made some losses, he might be more risk averse than he usually is. Some people might have the financial capacity but over time have reduced tolerance for taking up risk. Some people might want to invest more in equity based assets as they are worried that they might outlive their savings. So affordability of risk, willingness to take risk and financial goals have to be considered.
Risk profiling tools give an idea on the risk tolerance and risk taking capacity of a person. It should be used in conjunction with other factors such as investment skills, human psychological factors, financial capacity, financial need and external forces to have an investment plan that optimizes returns and brings capital appreciation.