Since these factors differ from investor to investor, it is observed that different people are comfortable with different levels of risk. For example, while some people can keep cool even when the market prices of stocks they have bought falls below their purchase price, there are several others who get jittery whenever such a thing happens.
It is important for every investor to find out the risk tolerance level because often while setting financial goals, investors either over-estimate or under-estimate their risk taking ability. However, the portfolio construct for every investor needs to be mapped to their risk tolerance level.Financial planners say at times it is seen that the goals for an investor are aggressive while he does not have the required risk appetite to have an aggressive portfolio. In such situations it is important to temper down the goals so that as risks are lowered, the financial goals, measured in terms of target portfolio amount, are also reduced. They also say that if the risk taking ability of an investor is measured correctly, it becomes easier to construct his portfolio to meet his financial goals.
At the initial stage he asks clients two basic questions:
- Which goal do you need this money for?
- For how long can you forget this money?
The three factors that determine how much risk an investor can take:
- Stability of in come,
- liquidity requirements and
- willingness to take risk.
If an investor's income is stable where the state of the economy doesn't affect his income, he could take some additional risks. So, a teacher is in a better position to take some risks than a person having income linked to the company he works for. One of the traits that determine the liquidity requirement of a person is if he does not have an emergency fund, and wants his investments to be such that he could withdraw money anytime he wants, then the person is quite risk averse. About the willingness factor, Beriwala says that if a person wants to multi ply his savings and can afford to see capital depletions for a few years, then he is willing to take risk.
To find out the risk tak ing ability of an investor, industry players depend on various types of tests that have a mix of subjective as well as objective questions, the ones which test situational reaction of an investor to probable gains or losses in his in vestments etc. Through these questions financial planners try to measure the risk taking ability of the investor to reach his financial goals and whether to suggest an aggressive or conservative investment portfolio for him.
According to industry players usually each investor is given a questionnaire to answer. It intends to capture personal information of the investor in order to integrate the existing investments of the person into his overall financial plan. The questionnaire also helps the financial planner to have some idea about the investor's investment horizon. Then his investor's risk taking ability is checked through questions relating to probable events in which he would need to get the invested money back. The questionnaire also aims to gauge the investor's awareness about various types of risks related to investments and also measures his aspirations in life that requires spending money. Finally, there are questions that try to elicit the client's intensity for loss aversion, financial planners said.
As a prospective investor who wants to put in place a financial plan, he should be ready with some basic information about him and his family. These include age of each of the family member, annual income, the number of earning member and dependents, the bank account details, investments already made, some idea about monthly expenses etc
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