Risk is the probability or threat of damage, injury, liability, loss, or any other adverse or unwelcome circumstance that may be avoided through some action.
Risk is a part of all of our lives. Everyone encounters a few risks every day, however insignificant they maybe. For example, one faces the risk of accident while driving to office or while crossing road. Different approaches are taken in different fields for efficient management of risks. Thus, it is safe to say – “Risk is everywhere and cannot be avoided. It is the unwanted subset of all possible outcomes from an event. And everyone tries their best to minimize their risks.”
In world of finance, risk is associated with unpredictability of returns. It can be both better-than-expected or worse-than-expected returns. This unpredictability is also called financial risk. As a matter of fact – while investing, everyone is trying for best possible returns (or positive risk) and at the same time avoiding negative returns (or negative risk or capital erosion). Everyone is happy when there are positive returns (or outcome) as it leads to a sense of achievement. However, when there is a negative return (or outcome), different people react differently due to the feeling of pain associated with negative returns. The intensity of one’s reaction is directly proportional to the amount pain incurred due to negative outcome. For example, if the pain (losses) are great many avoid doing that activity (investing into markets) altogether.
Why is Risk Profiling important?
After completing risk profiling, a financial planner understands mainly two things – 1) attitude of an individual or family towards risks, and 2) their mental and emotional capability to tolerate changes in their investment values over short term and long term. This helps the planner determine most suitable trade-offs between investment amount, available timeframe and risk taking ability for an individual or family to meet their goals.
If an individual or family expresses a strong desire not to see the value of their investments decline and is willing to forgo potential returns to achieve this, then this individual or family has a low willingness to take on risks, and are risk averse. Thus, they will need to make more investments or assign longer time frames to meet their goals in order to compensate their low risk taking ability.
Conversely, if an individual or family expresses a desire for getting highest possible return along with willingness to handle large swings in the value of their investment, then they have a high willingness to take on risk and are risk seeker. Thus, they will need to make smaller investments or assign shorter time frames to meet their goals.
An individual or family needs to understand that some risk is always involved with each investment. As financial planner, it is their job determine the level of risk an individual or families must take in order to meet their stated goals in life. And the planner must advise them on all possible trade-offs that need to be made in order to maintain proper balance between risk, investments amount, and available time-frame for meeting their goal. A financial planner will be able to come up with a sensible financial plan only after building proper consensus with an individual or family on all four parameters – risk, investment amount, time-frame and goal.
How to create Risk Profile?
Risk profiles can be created in a number of ways, one of the most common method is a risk profile questionnaire. All risk profile questionnaires generate a score based on an individual’s answers to various probing questions about various aspects associated with risk. Other common method is to have a discussion on various investment options and associated risk with each of them. However a hybrid method is most recommend. In this method, an individual or family has to answer a risk profile questionnaire which is followed by a discussion with financial planner to validate individuals understanding of risk with the results from risk profile questionnaire. This risk profile is then used by financial planners to help shape an individual’s investments.
Uses of Risk Profile
Effective risk profiling is a very useful tool for both financial planners and their customers. It helps in following ways –
• Build a common understanding between financial planner and their customers on the subject of risk management.
• Makes financial planning meetings more effective and meaningful by having a focused discussion around various investing options based on one’s risk profile.
• Help set and subsequently manage customer expectations properly to reduce incorrect buying and selling to generate better return on investments.
• Help deliver more value to customer leading to a lasting long term relationships.
• A transparent and effective risking profiling process ensures regulatory compliance for the financial planner.
In this article, we have introduced you to the basics of risk, how it is measured by a financial planner using various risk profiling methods. We also explained the possible uses of risk profile by financial planner to help in efficient handling of money and investments. For more information please feel free to reach out to us via email at – firstname.lastname@example.org or by phone – 91-9515475381.
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