In financial markets, the risk profile of an individual indicates his ability to take risk while investing. It is one of the important variables that a financial planner will focus on before recommending a product to an investor. Risk profile categorises the individuals in various segments such as conservative, moderate or aggressive.
Wealth management services providers use psychometric questionnaires to assess the risk profile of a client. The questionnaires comprise queries on day-to-day situations. Generally, the individual taking the test is told to choose one option that best describes his response to the situation out of the multiple options provided along with the question. The responses help the financial planners and wealth managers judge how the individual will react in a given situation. That forms the basis of the individual's ability to take risks. The questionnaires thus minimise the probability of any biases being introduced by wealth managers in the financial-planning process.
An individual taking the test should be honest while answering to the extent that he should select an option that best describes him and not the one he thinks is the right option. There are instances where the individuals get carried away by the environmental factor while responding to the questionnaires. Peer pressure and market sentiment are some such factors that influence the risk-profiling process. For example, an individual may appear to be a risk-taker when the stock market is in an uptrend. But the same person may appear absolutely risk-averse in times of falling stock markets. The changing moods of individuals thus make risk-profiling a difficult process for wealth managers and financial planners.
Other things remaining the same, with rising age, an individual's ability to take risk goes down. But there are instances that do not adhere to the observation. For example, a wealthy senior citizen with no family liabilities may be comfortable investing in equities. To understand the changes in the risk profile of an individual with rising age and changing asset liability structure, wealth managers prefer to do risk-profiling almost every three years.
Once the financial planner decides the risk profile of an individual, he suggests him a financial plan, taking into account his financial goals and the time horizon on hand. The financial plans undergo changes with the changing risk profile of the individual
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