Risk tolerance is a often used word by Advisers telling you where to invest. Not that the adviser himself understands the usefulness of this, or how to administer it, but it is now a done thing.

So typically a 20+ something, usually a pretty girl from the bank sits with a 48 year old ‘investor’ and asks him the usual questions. Now this man does not want to look like a coward (nor does she want him to) so he talks big and with huge bravado they decide that he can take a lot of risk.

Facts: He has a Rs. 85L ctc job, and if he loses it, he will get a Rs. 45 L  job. He has 2 daughters who are both planning to study abroad. He is paying Rs. 83,000 emi for his house, and Rs. 34000 emi for 2 cars. His mutual fund portfolio has about Rs. 12,00,000 his provident fund has Rs. 84L, and his house has a market value of Rs. 3 crores – out of which about 1 crore loan is pending.

He says he has a high risk appetite and wants to do a sip of Rs.100,000. The banker decides that this goes into a small cap fund and a mid cap fund, a balanced fund, and a foreign fund. Rs 25k in 4 funds for 2 years. After 2 years they will review the funds.

Well let us come to the myths of Risk Tolerance:

1. There is a particular magic number which tells you what is the clients risk tolerance: wrong, completely wrong. Risk is not so unidimensional as the books make it out to be. Take the above example, if he loses his job, and his wife gets cancer, he will have no clue what to do. So advise like sell your house and shift to your hometown will be met with a disbelief (but Subra I studied so much in such prestigious institutes, DON’T I DESERVE A Rs.85L job?????). He will have no money to pay the house emi or the car emi.
2. Clients understand their risk profile: another piece of nonsense. Clients, advisers,….nobody understands risk profile. You actually understand risk profile over a long period of time if the client talks to you regularly, and either you or the client maintain a diary of their thoughts. Thoughts and behavior. Otherwise it is just a game.
3. Risk profile is a one time exercise: wrong again. It is a continuous process. It should be done far more often than what we do. Like a tailor – you must measure the client every time he comes, not just once when you take him on as a client.
4. Older clients have less risk tolerance: absolute piece of shit. Deepak Parekh is 70, Vallabh Bhansali, Rakesh Jhunjhunwala, Uday Kotak – I am not sure what adjustment they are making in their portfolios. Sure, these are uber rich individuals and are not a good example, but look around you is there a 60 year old saying “all my money should be in the post office”? No. times are changing. The rules were made for a different world where people died at 68 in the US. Now the expectancy is 86. So equity will have to be there for a longer period. Clients have adjusted, the theory and the advisers have not adjusted.

yes there are many more…behavioral finance calls some of these as biases..in case you want further reading..