Investment Risk is the risk grade of an investor. In other words, Investment Risk means how much risk i can take as an investor. An investor doesn’t take it seriously and just throw a ball in the air. In day to day interaction there only Three types of risk i.e. High, Medium, and Low. At the time of investment if i tell my investment adviser that i can take high risk, he will suggest me direct equity exposure and few mid and small cap mutual funds. In the case of Medium Risk, suggestion will be Large Cap or Mid Cap mutual funds. Whereas, in a case of low risk, the options are FD, Debt mutual funds, etc. One product that is common across the spectrum is ULIP :). ULIP has a special place in heart and mind of the investment advisers. Now you must be wondering, what is the rocket science in this model and where is financial planning. The success of financial planning is dependent on Investment Risk. An investor fails to judge the Investment Risk correctly. Typically it is linked to the age of an investor. It is not true though age is one of the crucial factors. In some of the case, Investment Risk is very low even for young investors. Therefore, it is imperative to find right Investment Risk grade for successful financial planning.
The risk is always subjective and is perceived. You cannot quantify risk. Have you heard anyone saying that my risk is 8 on a scale of 10, or my Investment Risk is 4? Therefore, it often leads to misjudgment of same which in turn result in wrong investment decisions. I do agree that we cannot quantify risk with 100% accuracy, but we can find some way to calculate by considering all the factors that are responsible for Investment Risk. A more complex model gives relative weight to each of these factors, but it will be complex to understand.
Investment Risk – Important Factors
(a) Age: As i shared that Age is the most crucial factor to arrive at Investment Risk of an investor. It should not be the sole criterion to make investment decisions. In this case, investment advisers fail to notice the irony of life. It’s a thumb rule that at a young age you can take high risk. As the age increases, the Investment Risk decreases. Now at a young age, the income levels are low and investable surplus is less. When the investable surplus is low then the investor becomes risk averse i.e. takes less risk. On the other hand with the increasing age, the income increases but investment risk decreases. The fundamentals of financial planning fail to address this irony of life. Therefore, high risk at a young age will not be able to help in sound and reliable financial planning. The underlying logic that equity investment should be 100 minus your age has a flaw because amount/quantum of investment is not uniform. In this post, i am only highlighting the factors that influence investment risk. In future, i will address how to fix these anomalies.
(b): Income: Though i discussed income partially in the previous point most critical fact is the source of income and stability of same. A job is considered to be a stable source of income, but times are changing. Recently, i asked one of my reader who is working in reputed IT company that on a scale of 10 how will you rate your job stability. Shockingly, he rated 6. The fact of the matter is that with an increasing work experience, the job stability decreases. I discussed this in my post, Can you rely on your job?. Another friend of mine has a commercial property, and he get monthly rent of 90k. I consider his income to be more stable and will put him in high investment risk i.e. he can take high risk. In this case, both my reader and friend are of same age and earning almost same amount but investment risk is strikingly different.
(c) Plan B: This is my favorite point. Till date, i never heard read anywhere that investment adviser asks for the Plan B of an investor. In short, if the existing system collapses then what is the backup plan of an investor. The families with double income have Plan B in place, but it is important in the case of a sole breadwinner. The investment risk drops quite sharply in the case of single income family.
Plan B also include any inherited assets, rental income or existing savings that provide a cushion during financial distress. An investor may not be comfortable sharing these details. Therefore, i always refer it as Plan B.
(d) Liability: Existing liabilities is inversely proportional to investment risk. Lesser the liabilities more are the risk taking capability of an investor. Here financial planner or investment adviser fail to check the indirect liabilities. Direct liabilities are existing loans, Credit utilization, overdraft, etc. whereas indirect liabilities are if an investor is taking care of his parents. In short, the no of dependents on an investor also impact the investment risk. More no of dependents reduce the investment risk of an investor.
(e) Comfort Level of an investor: As an investor, i may fall in high Investment Risk category but on personal front i am not comfortable in taking risk higher than my comfort zone. In this case, investment adviser changes their gears immediately and shift to lower risk investment. The primary job of the investment adviser is to provide right financial planning advice to the client. In case, the client is not comfortable with high-risk products then he should convince him to start with little risk. For example, if i am not comfortable with equity products then i can start with Debt oriented Balanced Funds. Once i get a comfort level, then i may move to Equity-oriented Balanced Funds and then to Large-cap Equity funds.
Words of Wisdom: I believe that financial planning is not a rocket science. Once you understand the basics, an investor is in a better position to calculate his/her investment risk. According to that he/she can plan his financial portfolio. As an investor, we are afraid of taking the risk, but it’s a misconception that professional financial planning is risk-free. I observed financial planning be it free or paid, biased if the investment adviser is a commission agent/distributor or relationship manager of a bank (to achieve target). Though managing a big portfolio is not that easy but you should do your homework. You should always ask the commission structure of your financial/investment adviser. Based on that & your study, you can decide whether you would like to go ahead or not.
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