An understanding of the risk tolerance of investors is widely viewed as one of the most important factors in guiding investors towards successful investment programmes. Nonetheless, it remains an area that is still not properly addressed in Asia.

One of the fundamental tenets of investing is that there is always a trade-off between risk and return. Advisers must start by collecting information about how much risk a client is willing to take because, ultimately, that will determine the return that the client can reasonably expect. On top of this, the investor and adviser must also consider the ultimate goal of the portfolio.

Risk-profile categories generally range between those which apply to the most conservative investors and those which apply to the most aggressive of investors. Conservative investors have a low appetite for risk and prefer the security of capital and income streams to capital growth potential. On the other hand, an aggressive investor has a good understanding of the investment market and wants to invest for long-term capital growth.

The centre of this continuum, flanked by the conservative and aggressive risk profiles, is usually described as a balanced risk tolerance, where investors work toward medium- to long-term goals. While investors in this category want to lock in steady capital and income streams, they also have a reasonably healthy appetite for capital growth.

Critical To Financial Planning
Risk profiling is a critical facet of the financial planning and investment process. If the adviser gets it wrong and the client's risk tolerance is underestimated, the investment portfolio's return may not meet the client's expectations and, ultimately, they may never reach their financial goals.

Similarly, if the adviser overestimates the client's propensity for risk, not only is it likely that the client's goals will not be met, but the adviser also faces the risk of being sued for making an inappropriate recommendation. Such legal action is rare in Singapore at present, but it is increasingly common in other parts of the world such as Australia and the U.S.

No doubt this trend will be repeated here in Asia as clients become better educated and better informed about their legal rights, the investment markets and the products they buy. The issue with many risk-profiling exercises is that the questions and methods often appear amateurish, for two reasons: Most questions have not been psychologically tested, and some advisers don't place a lot of importance on this aspect of the planning process.

Any risk profile must be viewed with the goal of the investor in mind. If a person sets a goal of a 5% return based on their current assets and capacity to generate income, they don’t really need an aggressive portfolio generating 10% or more. What they may need is a balanced portfolio, and it would not make sense for them to take any extra, unnecessary risks.

It also important to remember that risk profiles can always change based on new information, and that sometimes investors need a little education in order to better align their expectations with their risk profile.

Donald Soo is the technical manager and senior financial planner of financial advisory firm Professional Investment Advisory Services Pte Ltd.