The mumbo jumbo of risk profiling or risk tolerance is now part of orthodoxy
Debashis Basu | 27 February 2014

In late September, The Securities & Exchange Board of India (Sebi) released a concept paper on Regulation of Investment Advisors. There is a lot of half-baked stuff there, which I have written about elsewhere and won’t go into them in this column. I am intrigued with one aspect of the paper on which there has been no discussion. In fact, there will be no discussion on it, except what you read here. It is called risk profiling, or risk appetite. As Sebi’s paper puts it: “The Investment Advisors or their representatives would be required to do adequate risk profiling of the client …Based upon the risk profiling… suitable investment advice should be provided. “

Until now, risk profiling or risk appetite/tolerance were terms used by a small set of devotees mainly in the asset management business. No longer; it is now part of the official lexicon – and therefore part of financial orthodoxy. Somebody inside Sebi must be a passionate new convert to the idea. On August 22, Sebi had issued a circular to mutual funds in which it said: “where a distributor represents to offer advice while distributing the product, it will be subject to the principle of ‘appropriateness’ … Appropriateness is defined as selling only that product categorization that is identified as best suited for investors within a defined upper ceiling of risk appetite.”

Is “risk profiling” a scientific process? Science is about establishing objective truth. Your risk profile would be determined by you subjectively by answering a financial quiz which range from the juveline to the ridiculous. If you have been curious about what to do with your money, have been reading the views of financial planners or surfing the net, you would have been exposed to “risk profiling” already. All the websites of fund companies and large financial distributors have this mumbo-jumbo on their sites, as well. If you are a thoughtful person, you would have been baffled in creating your own risk profile.

To ease your bafflement read what Jason Zweig, one of the finest writers on personal, writes in his book, The Little Book of Safe Money. One of the chapters is titled ‘Financial Planning Fakery’ subtitled, ‘What Is Your Risk Tolerance? No One Knows!’ where Zweig writes: “Its a conventional wisdom among financial planners that every investor has a distinctive appetite for risk. Most financial advisers will subject you to a risk-tolerance questionnaire, a series of between a half-dozen and a hundred questions supposedly designed to determine whether you are a spineless wimp or a wild-eyed thrill seeker. If you are perceptive, you will notice three peculiar things about these questionnaires. The first is that many of the questions have nothing to do with investing. You might, for example, be asked: if your flight is scheduled to leave at 7 P.M…I haven't yet found a question asking whether at 3:25 in the morning you would rather eat chicken, oysters, broccoli, or bananas…The second oddity about these questionnaires is that many feature the sort of trivia challenges you might face on a Wall Street version of Jeopardy: From 1926 through 2008, the average annual return on stocks was: (a) 11.7 percent, (b) 2.9 percent, (c) 9.4 percent.

“Any fifth grader could immediately see that what these questions test is not your tolerance of risk, but your knowledge of investing. If you get a high score, you are a master of Wall Street minutiae. But that doesn't mean you have a high tolerance for taking financial risk; it means only that you could go to a cocktail party and bore everyone to death. The third flaw in these quizzes is that some of the questions simply make no sense: If the stock market fell 20 percent, you would: (d) buy, (b) sell, (c) do nothing. But if you knew the answer to that kind of question, then you would already understand your own risk tolerance! And in that case, there would be no point in sitting through such a cockamamie quiz.”

Zweig goes on to expose the truth about risk profile, risk appetite or risk tolerance. ‘Risk tolerance’ is a myth, says Zweig. No one has a fixed attitude toward investing risk. Your willingness to take chances with your money will depend on a large number of factors, which keep changing.

Risk profiling is a piece of pseudo rationality with a ring of prudence to the term that in wrong hands can put off an investor from sound principles of investing – exactly the opposite of what it is supposed to achieve. Like all such such ideas it would be exposed as harmful decades later, by which time it would be too late. A new generation of savers would have arrived to be guinea pigs of a new ‘rational’ approach.