Sell Well - Grow Well, a joint initiative between SBI Mutual Fund and Wealth Forum, is an effort aimed at encouraging and guiding distributors on a path towards right selling - which we firmly believe is the best way to grow well on a sustainable basis. There are many facets to "right selling" - some which are behavioural and some technical. In the Sell Well - Grow Well series of articles, our endeavour will be to provide some perspectives on both aspects.

In this article, we explore the much discussed and much debated concept of risk profiling - which is often seen as the foundation for right selling. After all, how do you determine whether a product is suitable or not, if you do not know your client's risk profile - his attitude towards risk? There are simplistic models and comprehensive models for risk profiling that are easily available. In this article, we ask a fundamental question - is risk profiling at a client level correct? Does your client have only a single risk profile? Or, do we have to take a different approach towards risk profiling, if we have to indeed serve our clients better?

Rule of thumb may do your clients a lot of dis-service

There are a number of popular "rule of thumb" short-cuts that skip a formal risk profiling exercise and come to a "scientific" conclusion on an appropriate asset allocation for clients. One such "rule of thumb" is to subtract from 100, the investor's age. The resultant number represents the allocation to equity and the balance represents allocation to debt or cautious investments. Put another way, debt allocation = age of client. This means that a 30 year old should have 70% in equity (100 - 30) and 30% in debt while a 60 year old should have 40% in equity and 60% in debt. There is another rule of thumb which says keep reducing equity allocation progressively as your client approaches retirement and have a full debt portfolio on retirement, which is usually at 60 years of age. Such sweeping generalisations do complete disservice to understanding the individual, his needs and circumstances and his attitudes and preferences. We have seen several affluent senior citizens who have met their financial obligations towards their families, and now have a very significant proportion of their assets in equities. Is this wrong merely because they happen to be over 60?

Hypothetical questions will only give hypothetical answers - not real answers

On the other hand, advisors who go through a comprehensive effort of conducting a risk profiling exercise, often fret at the rather deceptive conclusions that emerge from this exercise. In a classical risk profiling exercise, your client is supposed to answer a set of hypothetical questions and those answers determine his risk tolerance. The big flaw in this process is that hypothetical questions get hypothetical answers - which often depend on the current frame of mind of the investor, at the time he is responding to your risk profiling questionnaire. And, we then go on to build asset allocations purely on the basis of these hypothetical answers, whereas, when real life situations confront the client, he may react very differently to the hypothetical answer he gave to your hypothetical question. One of the favourite hypothetical questions that finds its way into most risk profilers goes something like this :

If you have invested recently in the equity market and the market goes down by 20% over the next 3 months, how would you react :

1. Will see this as a great buying opportunity and look to invest more

2. Will be a little concerned, but will stay put as I am a long term investor

3. Will be very concerned and will look to exit as soon as I am able to recover cost

4. Will be very concerned and will exit right away and invest the balance in safe avenues

If your client is filling out this risk profiler just before he intends investing in equities, he is already favourably inclined towards equity, perhaps because he thinks markets will go up in the next couple of years. In such a frame of mind, he is quite likely to tick a or b, but far less likely to tick c or d - as he has already formed an opinion that he would like to invest in equities as he believes markets will trend upwards. Once he has invested and markets trend downwards and stay there for a few months, ask him to take another risk profiler given to him by another advisor, but with the same question - and you may be surprised to see him more willing to tick c or d and far less willing to tick a or b.

Has his risk profile changed? Maybe not. Maybe he just gave a hypothetical answer to a hypothetical question - but when presented with a real life situation, his response was completely different.

Does your client have only one risk profile?

Then again, there is another dilemma for advisors who wish to actually understand their client's risk profile and advice accordingly. Does your client have only one risk profile? If a 35 year old client comes across as a very cautious individual, would you go purely by his risk profile and recommend pure debt avenues for his retirement savings, which have a time horizon of 25 years? Or, take the case of say a 48 year old client, who is quite a risk taker and an experienced equity investor. Would you recommend an equity heavy portfolio knowing fully well that there is a substantial outflow due within the next 2 years to fund his daughter's international education?

The fact is that the same individual can and often does have different risk profiles for different streams of savings, which are meant for different goals across different time horizons. Carrying out a single risk profiling exercise and then applying results from there across your client's entire portfolio, may not be the best advice to give him.

What really is your responsibility : risk profiling or risk management?

So, how then do you actually use risk profiling to serve your clients better? How do you avoid the pitfall of hastily putting them into one of your 5 pre-defined buckets as quickly as possible, which may actually do more dis-service than good for them?

We would submit that the job of advisors is actually moving rapidly from risk profiling to risk management : to helping clients understand and deal with risk. There is much less value add in simply profiling and slotting a client than there is in helping them understand what risk is really all about and how best to deal with risk, so that you can put them firmly onto a path of wealth creation. It is easy to quickly slot your client into one of five risk buckets, produce an asset allocation, recommend funds on that basis, and then move on to the next client. But, if we all appreciate that more than 90% of portfolio returns are actually driven by asset allocation, shouldn't we be moving from risk profiling to risk management to help clients get an optimum asset allocation that you think is right for them - irrespective of what your profiler score throws up?

As many writers have opined, the greatest risk that an individual faces relating to his savings is not the risk of market volatility or capital erosion, but the risk of outliving his savings. The impact of inflation over the long term health of any financial portfolio is far more debilitating than any market volatility - whether over a 5 month period or a 5 year period. There are several ways in which you can manage volatility - but there is no way you can manage inflation - other than investing wisely to beat inflation or investing cautiously and succumbing to inflation by reducing your standard of living progressively. Advisors are increasingly having to do a lot more counselling for clients who are getting unnerved by continuing market volatility and are thus more willing to compromise the long term health of their financial situation, to address near term pains in their portfolios.

What then must you do?

What then must you do to help your clients invest appropriately? How must you use risk profiling as an effective right selling tool? Here are some thoughts :

1. Don't treat your risk profiling questionnaire as some boxes to be ticked within 5 minutes, before you proceed towards your sales pitch. Treat it as a conversation enabler, that helps you understand your prospective client better and helps you make a judgement of what aspects of risk he may need to understand better

2. Don't ask hypothetical questions which will only get hypothetical answers and then cast a real life portfolio based on these hypothetical answers. Ask real life questions and get actual answers. Don't ask for example how your prospective client would react to a market correction. Ask him instead what he did in 2008 when the market crashed, in 2009 when the market recovered swiftly and in the 2010 - 2013 period where the stock market gyrated strongly, but within a large range. Ask your prospective client what he did with his debt investments in the months of June, July, August and September 2013, when debt markets demonstrated more volatility than perhaps ever before. The last 5 years have been such a roller coaster ride for financial markets, that you really don't need to dwell on hypothetical questions. Understand what your clients did while on this roller coaster, understand why they did what they did, understand what they have taken away from this roller coaster ride and you will be in a far better position to actually understand their real risk profile.

3. Understand that a client rarely has a single risk profile. In reality, risk profile can be different for different goals. Understand your client's attitudes towards risk for each specific financial goal and suggest your asset allocation separately for each goal. Its not just about time horizon - 2 goals of the same client, having the same time horizon of say 10 years, may actually have two different risk profiles and therefore different asset allocations, based on the criticality or emotional quotient of these goals.

4. Move on from mere risk profiling to helping clients understand and manage risk. If you think that what is coming in the way between your client and his secure financial future is only his attitude towards market volatility, and that this attitude can pose a bigger risk to him that he now realises, its time for you to stop the profiling bit and get on to the counselling bit. Its time for you to educate and persuade your client that he needs to understand that the bigger risk he is running is actually outliving his savings and not the risk of market volatility. To the extent you are able to get clients to understand and deal with risk, you will be serving them far better than merely going by the prototype answers of a standardised risk profiling questionnaire.

Risk profiling : is it for your client's benefit or for your benefit?

This is of course easier said than done, especially in challenging market circumstances where "risk assets" like equities have in several years only shown their risk side and not their returns side. This is a time when your own convictions about the inevitability of market cycles get severely tested. This is also a time however when holding onto your convictions and helping your clients stay the course through rough markets can actually help your clients secure their financial futures far better in the long run.

As long as your risk profiling exercise helps you understand what aspects of risk management you need to work with your client on, risk profiling has huge merits. If risk profiling merely is about filling out a predefined questionnaire, which then gives out an automated score and suggested asset allocation - with no effort to guide the client on what you think is appropriate, think of whether you are really doing the best for your client or merely safeguarding yourself against mis-selling claims.

All articles in the Sell Well - Grow Well section are created by Wealth Forum. These are not to be construed as opinions given by SBI Mutual Fund.

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