How to assess risk appetite better?

How we respond to a risk could be known only after the actual risk happens and like all the prior exercise seems futile. The problem with typical risk profiling questionnaire is that it enquires one about how would they respond to an imaginary situation.

After a deep thought, they pick one of the given choices at the bottom of each question. The catch here is thought,' which is what we lack when we act in haste and/or during crisis, our response? tends to be more instinctive than conscious. So, how would we assess an individual's risk appetite with more accuracy? The answer could lie in our historical behaviour.

We, as advisors, have task at hand in finding out the numerous instances on how an individual had reacted to various situations in his life. For instance, in the respondent's life, how had he tackled a stressful event, what were his first reactions to a major event, what are his feelings during an opportunistic moment?

These findings mayn't truly depict the actual risk profile, but certainly would hint at his intuitiveness and the advisors get a glimpse of how that person would behave at a particular situation.

Is risk profiling critical for the investor or the advisor? In a way, it's more important to the advisor as it helps not only in understanding the investor's risk appetite, but also in knowing their reflexes, which serve the advisor better at dealing with the investor at difficult times.

When starting a financial plan, typically investors are prepared (psychologically) to pursue a dedicated and diligent effort at bettering their personal finances or/and getting into better shape, financially.

This frame of mind also enables them to take certain decisions which otherwise they wouldn't be taking.

But, when the scenarios change not only for bad, but even when they stumble upon an opportunity which was completely unplanned earlier, all the earlier planning goes for a toss.

The eagerness to make better out of that prospect assumes higher importance and now they would be ready to make compromises to the original plan, which no more remains sacrosanct. I wouldn't out rightly say this is wrong, but would want to highlight how a change in the mood influences an investor even as to alter to some of the priorities.

Despite all the profiling process and identifying the investment avenues, I've experienced that the investment style would often be impacted by the change in mood or situation of the investor. The very rationale for the investment done would be put to test during periods of market volatility.

It's in these intermittent stages of the investment period, a very difficult time even for the advisors as they not only have to guard their own biases, but stay up an ace ahead of the investor's whims.

It's natural and human for the investor to lose faith or strength in an investment model which begins to perform or deliver contrary to the assumptions made at the beginning? For instance, in general, a financial model would be built upon various assumptions and one such crucial one is the rate of return.

When invested, say for a period of five years, an investment avenue would give an annualized return of 10 per cent. But in reality, this wouldn't be a linear one and is bound to be volatile.

For example, a lumpsum investment for five-year period yielding six per cent is almost equal to a variable return of 4 per cent, 8 per cent, 8 per cent, 6 per cent and 4 per cent compounded at each year. But how could we keep the investor's worries at bay when the returns turn inconsistent except to fall back in history of that investment which tends to give an average compounded rate of six per cent.

How could one keep a lid on the inhibitions of the investor during these periods, particularly during the very first year the investment return is below the average assumed return.

Situations of these kinds sap the confidence of the investor and examine the assumptions of the advisor alike. And we encounter such situations at random in our investment life. For a successful advisory, the investor's real nature needs are to be comprehended by the advisor and of course, the best method is to work over a period of time.

It's also highly imperative for the advisor to know the history (not just a typical investment history) and other preferences, interests and hobbies in life.

An experienced advisor would draw upon various instances in any/all of these aspects of the investor's life to come up with insights that throw a clearer representation of their inhibitions, temperament and reactions to lead to an eventful investment experience.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)