Risk Isn't Just Numbers: Building Investor Profiles with Psychology and Economics
In the world of finance, the combination of risk capacity and risk aversion constitutes what the industry terms as an investor's risk profile. Investments are deemed suitable for an investor only if the investment’s risks fall within the limits of both the individual's risk capacity and risk aversion.
One useful approach to navigating the practical challenges of assessing risk profiles is to distinctly understand:
- Risk Capacity
- Risk Aversion
1. Risk Capacity
Risk Capacity is the objective ability of an investor to take on financial risk.
Key factors influencing Risk Capacity:
- Investment time horizon
- Liquidity needs
- Income and overall wealth
- Applicable tax rates
Important Note:
Risk capacity is relatively immune to psychological distortions or subjective perceptions. It depends purely on economic circumstances.
2. Risk Aversion
Risk Aversion refers to the psychological traits and emotional responses that determine an investor’s willingness to accept financial risk.
Indicators of Risk Aversion:
- The degree of emotional pain experienced with financial loss.
- The absolute amount of loss (in Rupees) that is deemed unacceptable by the investor.
- A phenomenon known as loss aversion:
Investors feel more sadness on losses than happiness from an equivalent gain.
Example:
If asked, “Would you feel comfortable losing 10% of your trading capital?” versus, “Would you feel comfortable losing ₹10,000?” (assuming ₹1,00,000 capital), most people react more strongly to the absolute rupee loss. This distinction helps better gauge real-world loss aversion.
Factors Influencing Investor Risk Profiles
Investor risk preferences are shaped by multiple influences, which can be broadly categorized as follows:
a) Genetic Predisposition
- Studies show 20%–40% of variations in equity exposure can be explained by genetic inclination toward risk-taking.
b) Financial Anamnesis
- Influences from family, friends, and community investment philosophies.
- Early exposure to risk-takers or risk-averse environments.
c) Investment Diaries
- Past personal investment experiences, especially during formative years (ages 16–25).
d) Investment Histories
- Macro-economic conditions experienced during one's lifetime.
- Example: Individuals who lived through the Great Depression exhibited more conservative investment behavior even 40 years later.
e) Community Effect
- Moving into communities with higher stock market participation can increase an individual’s probability of investing by about 4%.
f) Social Interactions and Cultural Differences
- Political stability, social cohesion, and cultural factors influence long-term vs short-term investment preferences.
g) Risk as Feelings Effect
- Decision-making about risks is often emotionally driven rather than rationally evaluated.
Practical Application: Risk Profiling Questionnaire
To better assess an investor's emotional response to financial loss, the following scenarios can be used:
Emotional Sensitivity to Profits vs. Losses
Expectations on Returns and Losses
Scoring System for Risk Tolerance
Conclusion
- Score below 95: Requires further individual counseling before engaging in high-risk trading.
- Score above 95: Considered suitable for trading activities, including Futures and Options.
Final Thought
Understanding the emotional and economic dimensions of risk-taking is critical for building a resilient investment or trading strategy. A scientifically designed risk profile assessment ensures suitability, better decision-making, and ultimately better investment outcomes.
Author
Nikhil Dayanand Baljekar
SEBI: INH000009001
