Alot has been said and written about the fact that before investing in stock market or equity linked products one needs to assess one’s risk taking ability, or in other words risk tolerance levels. This helps in identifying whether an investor is risk averse or risk tolerant.
Risk averse investors would be categorised as people who would not like to take risk over and above a certain threshold even at the expense of losing out on the higher potential returns, while risk tolerant investors are those who are willing to take some risk in the trade off for higher returns. Risk averse investors are more likely to prefer safe investment products, while the latter would be more keen to have part of their investment portfolio in equities.
Several financial websites or even financial planners and advisors have devised various types of questionnaires which enable one to determine what category the potential investors would fall into. While it can be argued that this categorisation is essential in preparing a suitable investment portfolio, along with the consideration of goals and time horizon, it may not completely address the investor’s actual behavior during turbulent times.
Let us consider the case of Ram Prasad (35), a senior manager with an auto firm, who was categorised as risk tolerant at the time of starting his investment in equity mutual funds way back in 2007. Prasad was investing for his retirement which was nearly two decades away and he had mentioned in the risk profiling questionnaire that he was willing to take the risk in pursuit of higher returns.
A point to note was that he had started investing in a year when equity markets were performing very well and delivering above average returns. Then came the financial crisis in 2008 when stock markets tanked and most of the equity mutual funds were in the red. When Prasad’s equity funds portfolio fell by around 20 per cent he decided to stop all his equity investments and worse, decided to pull out whatever he had invested in the markets. He felt that if he waited a little more, then his portfolio might further get eroded.
Prasad behaved in this manner due to the perceived risk of markets falling further. This changing perception is very dangerous for investors and can do a lot of damage to their portfolios during extremely volatile market situations. History proves that a majority of the investors, may fall in the risk tolerant category when the risk profiling is done, but during extreme market situations it’s their risk perception which motivates them to act in an unusual manner. Therefore, we see investors selling in a bear market perceiving that the equity markets might fall further and they invest the most during bull markets believing that the markets might rise further.
How can we manage our perception? Our perceptions change with changing situations. Financial planners and advisors should spend more time with their clients and take them through the data of some of the worst turbulent periods and explain how things panned out for different investors. Apart from harping about the great rewards of being invested in equity, advisors need to also explain the potential risk which equity markets carry. Perceptions can change only with time. It is not possible to change your opinions or the way you look at things overnight.
Risk profiling questionnaires can be made a little more interactive and efforts need to be taken to understand products in detail. The risk also arises in not knowing how a product behaves in a given situation. It’s important for the advisors and planners to spend more time with their clients, especially during turbulent situations, helping them understand the situations and navigate the difficult period so that they don’t behave in a manner which is detrimental to their investments.
Finally, not only risk profiling, but a combination of factors such as your time horizon and investment objectives should also be considered while building an investment portfolio. Things done right in the initial stage will go a long way in achieving the desired results.