While there are many aspects of life where an individual must assess risk, making an assessment of ﬁnancial risk that your client (investor) is willing to take is something most advisors struggle to evaluate correctly.
This is mainly due to the complexities involved in assessing risk, such as:
- Technical jargon surrounding the subject of risk – Standard Deviation, Sharpe ratio, Treynor ratio, etc.
- Inability to articulate what is the trade- off – Everyone is looking for an investment with zero risk and maximum return.
- Difference between Actual behaviour and Professed behaviour.
- Hearsay Bias– News and stories that we hear about people making signiﬁcant gains or losses.
Expanding on each of these to explain better.
Jargon – a few misnomers
The most common statistical measure used to evaluate risk is Volatility i.e. price variation on both Upside and Downside. So, if something has zero volatility, it basically means that there is neither upside nor downside. Frankly speaking, all investors want upside volatility (positive surprise). What they do not want is negative volatility.
The second issue is that this is statistical in nature. It does not mean that it may never happen. For example, the investor may put money into a Fixed Deposit (no upside or perceived downside risk to capital along with ﬁxed interest, hence volatility is zero), but what happens if the Bank goes bust? Even if the chances are very remote, it still exists, and this risk is not captured as volatility.
Therefore, it is important for advisors to apprise their clients on how much downside risk is present, and what is the probability of that. Also, it is important for all the advisors to have a considerable amount of knowledge of marketing risks and of the latest wealth management software and the best mutual fund software for IFA to combat the worst possible scenarios.
Simply put, what is it that we are willing to give up in the hope of getting something more. This is basically the philosophy that “There are no free lunches”.
The very fact that investors are promised a higher return is that the probability of that return is NOT 100%. More importantly, there is a probability that the Principal may get eroded.
This is also the reason we advise investors to not put all their eggs in one basket, however lucrative it may sound. There are no “sure shot” winners.
The other very important factor to consider is Time.
The trade-off on the return could be that we expect the investors to be patient to see the results that we have planned for. And during this period, investors could see down-swings (or volatility) in their investments.
Actual vs. Professed Behaviour
Even the best ﬁnancial plans and decisions face the uncertainties of future. While ﬁnancial investments hardly behave as predicted, how your clients react to it, may also differ from what you anticipated.
The wider the deviation from what was “predicted”, the more we, and investors, question our past decisions.
The most important factor seems to be “Recency Bias”. This works both ways:
When things are rosy - investors think they can take higher risk, because they feel that future is going to be great, and it is “unlikely” that there will be a negative outcome or downside.
Similarly, when things are gloomy – investors tend to be more pessimistic and expect the situation to deteriorate further. This often leads to panic selling by investors and they tend to forget the “time horizon” that they had invested for.
We live in an age where news ﬂow is constant – to the point that it becomes noise. Making informed decisions becomes extremely diﬃcult, especially in times of stress.
This takes many forms, main among them is FOMO – Fear of Missing Out, on some action that “others” are taking.
Due to the above reasons, the normal risk proﬁling that we do for our investors– “Conservative”, “Balanced”, “Aggressive”, etc. does not work. Partially also because they have connotations that go well beyond the narrower scope of ﬁnancial risk we are trying to quantify. An added level of diﬃculty arises when we try to assess the risk for our clients and make a recommendation.
We seldom assess the real-life ﬁnancial expectations of investors on risk – beyond some questions that are routinely asked – to “gauge risk” through a psychometric proﬁling. This is used to derive a score that helps to categorize your investor in various risk proﬁles such as Conservative, Balanced, Aggressive, etc.
How to Quantify the category, so that it translates into a Model Portfolio, is seldom done well.
We recommend a set of few very speciﬁc questions which can address the investors’ concerns such as:
- What is the maximum loss that an investor is ready to see on the principal over a speciﬁed period?
- For taking this risk, what is his return expectations?
- What is the investment time horizon?
- How much short-term erosion of principal is the investor willing to see in the hope of long-term gains?
These inputs can be used to Quantify and create a framework which can describe the characteristics of the desired portfolio that an investor wants. Creating this framework is the starting point for an advisor for their clients as it will help tide over extreme short-term volatility which leads our clients to ask: What should I do now?
At Fintso, we have created the framework to not only convert the above answers to ﬁnancial metrics, but also provided the constraints that real life imposes.
Using this framework, we have developed the algorithms that advisors can use for their clients to:
- Create an actual Asset Allocation for investors’ portfolio based on our recommendations.
- Monitor their portfolios Periodically Review their portfolios.
- Incorporate changes in portfolios for new opportunities, products and change in ﬁnancial goals.
We shall present our Asset Allocation techniques using this risk framework in subsequent papers.
Fintso is a fintech platform that provides solutions to financial entrepreneurs to address their needs of research, advisory, product access and client engagement. We empower entrepreneurs, to do more for their clients while retaining their identity.
The team at Fintso has deep domain expertise on the Indian investment and wealth management space and in cutting edge technology.
Meet the Investment Team:
Co-Founder and MD
Rajan was a member of team who launched India’s 1st Mutli-Manager and Fund of Funds AMC concept in India. He had also launched India’s 1st Multi Asset, Multi Product “WRAP” Accounts with online action capabilities. These WRAP accounts were Ranked with a 4 Star by Value Research for process and performance. With more than 2 decades of experience in financial markets, Rajan’s accomplishments include establishing successful B2B businesses supporting the financial entrepreneurs. His vast experience & deep understanding of advisor’s need help us build a strong framework of actionable insights.
Co-Founder & CEO
George was part of the Investment Committee and has been instrumental in designing the algorithms for products and advisory in his previous firm. George had helped design the Financial planning software and created the models for Asset Allocation using Efficient frontiers way back in ’00 while in Deutsche Bank. With over 25 years working with Ultra-HNI clients, George has a deep understanding on designing solutions for the end clients.
Head – 3rd Party products
Over the past 8-years in the Indian financial markets, Kumar has developed an intrinsic understanding of different asset classes and built an excellent product knowledge by working for top wealth management firms. He was a core member of the team that created the processes that were used for fund selection in both these previous organizations and is now working to bring the same level of research and advisory to financial advisors.
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