I got into a spat with an IFA about risk profiling. She was talking about risk profiling, and I said it is a waste if an IFA does risk profiling without understanding its limitations. No clue whether she understood what I said.

Sorry to start with such a blunt statement, but it is true.

Let us start at the beginning.

What is risk profiling: it is the process of finding the optimal level of risk for your (your clients) portfolio. It consists of risk required, the ability to take risk (mathematically) – called risk taking ability, and risk tolerance (mental ability to take standard deviations, as well as permanent loss of capital).

1. Risk Required: If you can put in Rs. X for ‘n’ years, what is the ‘r’ that you require to arrive at the Amount that you need to achieve a particular goal. This is of course a purely mathematical concept. Based on this number (and other parameters) you can know how much money you need to allocate to equity and how much to high quality debt. So if you need to get say 11% for a period of 15 years, you / your IFA may suggest 60% in equity (hoping to get 13%pa) and 40% (hoping to get 8%p.a.) giving a weighted average of 11%.
2. Risk Taking ability: this is again mathematically decided by an elaborate questionnaire that asks a person how many people are dependent on him, his ability to get a new job if he were to lose his existing one, qualifications, children, parents, spouse, other assets, This decides the risk taking ability that a client has. Normally, clients underestimate this, because they cannot see risks like disability, illness, going into a coma, dramatic drop in income (taxi drivers hit by Ola/Uber) etc. So the IFA has to play the devils advocate here. Most clients cannot (will not) see the risks clearly.
3. Risk Tolerance: this can at best be done by psychometric testing! and like all human responses, this too has 2 sets of responses – one which the client feels, and one which he says to impress the person asking the question. It takes a lot of experience for the IFA to be able to understand/ interpret the answers given by a client. Most IFAs will give this portion a quick by pass – because neither the client nor the IFA want to waste too much time on this MOST IMPORTANT part of the risk profiler.