Client Risk Profiling
Three different things
- Risk tolerance: the client's psychological willingness to accept volatility and loss.
- Risk capacity: the financial ability to absorb loss without derailing goals, driven by income stability, emergency fund, liabilities and horizon.
- Risk required: the return needed to reach the goal from the current corpus.
Advice should sit at the lowest of these. If the required return exceeds capacity, change the goal, the savings rate or the horizon, not the risk profile.
Building the profile
Collect KYC data, age, dependents, income, expenses, assets, liabilities, insurance cover, emergency fund, time horizon, liquidity needs, investment experience and past behaviour in a drawdown. Use a documented questionnaire, score it consistently, and record the client's own answers. Review periodically and whenever circumstances change materially.
Behavioural traps for the adviser
Loss aversion, recency (chasing last year's winner), overconfidence, anchoring to the purchase price and herd behaviour. Good profiling records likely behaviour, not just stated preference.
Worked example
A 28-year-old engineer with stable income, a Rs 5 lakh emergency fund and a 25-year horizon scores low tolerance after a market fall. Capacity is high, tolerance is low. A suitable recommendation stays near the low-tolerance allocation, say 40 percent equity, and the file records that the lower of tolerance and capacity governed the advice. Pushing 90 percent equity because the client is young is a suitability failure.
Traps
Assuming young means aggressive. Using one questionnaire unchanged for every client. Redrawing the risk profile to justify a product already sold. Failing to document a client's refusal of suitable advice.