WEALTH
MANAGEMENT
Module 3
RISK PROFILING AND ASSET
ALLOCATION – RISK PROFILING
What is Risk?
✓ All investments involve some degree of risk. In
finance, risk refers to the degree of uncertainty
and/or potential financial loss inherent in an
investment decision. In general, as investment
risks rise, investors seek higher returns to
compensate themselves for taking such risks.
✓ Every saving and investment product has
different risks and returns. Differences include:
how readily investors can get their money when
they need it, how fast their money will grow, and
how safe their money will be.
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Type of Risk
Every individual has their own risk taking capacity.
Your risk-return profile is your level of risk tolerance.
There are three types of risk return profiles:
[Link] i.e. you take minimal risks ensuring
your funds are secure. You prefer investing in post
office deposit schemes, bank fixed deposits,
government bonds
[Link] i.e. you are willing to take some risks and
prefer investing in mutual fund schemes
[Link] i.e. you are willing to take high risks
and prefer investing in equity, commodities markets
and you may even be speculating for returns. 3
Risk and Return
There is an important investment principle which says the
level of your returns depends on the level of risk you
take.
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Risk Profiling
❖ Risk profiling is a process for finding the
optimal level of investment risk for your client
considering the risk required, risk capacity and
risk tolerance, where,
❖ Risk required is the risk associated with the
return required to achieve the client’s goals
from the financial resources available,
❖ Risk capacity is the level of financial risk the
client can afford to take, and
❖ Risk tolerance is the level of risk the client is
comfortable with.
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Risk Profiling
How much risk you
PREFER to take.
(Psychological)
Risk
Tolerance
Risk Risk
Required Capacity
How much risk you
How much risk you
can AFFORD to take.
NEED to take.
(Financial)
(Financial)
Risk Profiling
Risk required and risk capacity are financial
characteristics which can be calculated using
some financial planning software.
Risk tolerance is a psychological characteristic
which is best determined by way of a
psychometric test.
Risk profiling requires each of these
characteristics to be separately assessed so that
they can be compared to one another.
Each of these three risk aspects has an
impact on the selection of an appropriate
investment strategy.
Contradictions in the Risk Profile
Clients’ psychological willingness to take risk
can sometimes clash with their financial ability
to do so.
For example, if someone has a high risk
tolerance, but has a finely balanced financial
situation.
When such a conflict exists, financial advisers
need to take time to counsel the client and
explain the consequences of the mismatch.
You’ll need to explain the consequences of low
or negative returns to more aggressive investors
with less liquid wealth.
Risk Profiles
Moderate:
Investor can tolerate
moderate level of risk in
exchange for relatively
higher potential returns
Moderately conservative: over the medium to long Moderately aggressive:
Investor is willing to term Investor is keen to accept
accept small level of risk high risk in order to
in exchange for some maximize potential
potential returns over the returns over the medium
medium to long term to long term
Aggressive:
Conservative:
Investor is willing to
Investor’s top priority is
safety of capital and
Typical accept significant risks to
he/she is willing to accept Risk maximize potential
returns over the long
minimum risks and,
hence, receive minimum Profiles term and is aware that
he/she may lose a
or low returns
significant part of capital
Risk Profiles
RISK PROFILE INVESTMENT STYLE
Conservative Your primary investment goal is capital protection. You require stable growth
and/or a high level of income, and access to your investment within 3 years.
Moderately Your primary investment goal is capital protection. Investors in this risk profile
Conservative require fairly stable growth and/or a moderate level of income. Your
investment term is 3 years or more.
Moderate Your primary investment goal is capital growth. You can tolerate some
fluctuations in the value of your investment in the anticipation of a higher
return. You don't require an income and you are prepared to invest for 5 years or
more.
Moderately Your primary investment goal is capital growth. Investors in this risk profile can
aggressive tolerate a fair level of fluctuations in the value of you investment in
anticipation of possible higher returns. You don't require an income and you
are prepared to invest for 5 to 10 years.
Aggressive Your primary investment goal is long-term capital growth. You can tolerate
substantial fluctuations in the value of your investment in the short-term in
anticipation of the highest possible return over a period of 10 years or more.
RISK MANAGEMENT
Risk management is a crucial
process used to make
investment decisions. The
process involves identifying and
analyzing the amount of risk
involved in an investment, and
either accepting that risk or
mitigating it.
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Risk identification
✓ Every investment is fraught with
risks.
✓ Investors must analyze the risks in
asset classes like debt and equity
and find out ways to minimize
them.
✓ Risk management in investments
is the process of identify, analyze
and mitigate the uncertainties in
the investment decision
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Risks in fixed income
As investors are gradually
looking at debt mutual funds as
an alternative to bank fixed
deposit, they should keep in
mind that such funds from asset
management companies have
some risks. Debt funds have
❖ Credit risks
❖ Interest rate risks
❖ Liquidity risks 4
Credit Risk
✓ After investors invest in debt funds, the fund house collects all
the money and invest in instruments like government bonds
and corporate bonds.
✓ Government bonds have a sovereign guarantee and are even
safer than bank fixed deposits. However, corporate debt
paper carry very high credit risks.
✓ Credit risk takes into account whether the bond issuer is able
to make timely interest payments and pay the principal
amount at the time of maturity of the bond.
✓ If the issuer is unable to do so, then the particular bond is
likely to default.
✓ Bonds issued by state-owned companies like NTPC, ONGC,
Coal India, etc., have high credit rating of AAA and carry a
quasi-government guarantee.
✓ Investors should not invest in funds that have high exposure
to companies having a large leverage.
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Interest rate risk
✓ Any change in the price of a bond because
of changes in the interest rate can affect
investors. Higher the maturity profile of the
fund, more prone it is to interest rate risk.
✓ In case of increasing interest rate
scenario, it will be positive for funds having
a shorter maturity profile.
✓ On the other hand, a falling interest rate
scenario will be beneficial for those funds
which have a longer maturity profile.
✓ So, if you invest in debt funds of mutual
funds, align investment horizon with that of
a fund, which will help to mitigate the
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interest rate risk.
Liquidity risk
✓ Investors should also look at
liquidity risks of the funds, which
means how quickly the fund
manager can sell the particular
paper in case of any downgrade.
✓ Corporate bond of high rated
companies are more liquid than
the lower rated paper.
✓ If the fund manager is selling the
paper under pressure, then
investors will suffer losses.
Reinvestment risk
✓ Fixed income investors also face
reinvestment risks.
✓ If the interest rate falls and the
bond matures, then the investor
will not be able to reinvest the
maturity amount for higher rates.
✓ Like equity funds, even debt funds
are market linked instruments and
there is no assured returns or
capital preservation.
Risk in equity
✓ Markets volatility remains the most
important risk in equity investment either
directly or through mutual funds.
✓ It can impact investments if stock prices
fall steeply or remain down for a long
period of time.
✓ Ideally, to beat market volatility investors
should invest via systematic investment
plans (SIPs) of mutual funds.
✓ Investors must take note of the fund
manager, his long-term track record,
asset management company, its
philosophy, fund expenses and
investment style.
Industry specific risk
✓ Equity investments also face industry
specific risks and returns will suffer if the
particular industry is going through a
cyclical downturn.
✓ An investor should find out about the
risks involved instead of just worrying
about the returns.
✓ Our mindset is driven towards return and
reward rather than risk and loss. And
greed and fear is what finally determines
your wealth or lack of wealth.
Methods of risk Measurement
Some common method of measurement of
risk are:
1. Standard deviation
2. Alpha
3. Beta
4. Sharpe ratio
5. Treynor ratio
6. R-squared
Standard Deviation
✓ Standard deviation measures the
dispersion of data from its expected value.
✓ The standard deviation is used in making
an investment decision to measure the
amount of historical volatility associated
with an investment relative to its annual
rate of return.
✓ It indicates how much the current return is
deviating from its expected historical
normal returns.
✓ For example, a stock that has high
standard deviation experiences higher
volatility, and therefore, a higher level of
risk is associated with the stock.
Alpha
•Alpha refers to excess returns earned on an investment above the benchmark return
when adjusted for risk.
•Active portfolio managers seek to generate alpha in diversified portfolios, with
diversification intended to eliminate unsystematic risk.
•Because alpha represents the performance of a portfolio relative to a benchmark, it is
often considered to represent the value that a portfolio manager adds to or subtracts from
a fund's return.
Alpha of portfolio = Actual rate of return of portfolio – Expected Rate of Return on Portfolio
Expected rate of return of portfolio = Risk-free rate of return + β * (Market return –
Risk-free rate of return)
Beta
✓ Beta is another common measure of risk.
✓ Beta measures the amount of systematic risk an
individual security or an industrial sector has
relative to the whole stock market.
✓ The market has a beta of 1, and it can be used to
gauge the risk of a security.
✓ If a security's beta is equal to 1, the security's
price moves in time step with the market.
✓ A security with a beta greater than 1 indicates
that it is more volatile than the market.
✓ Conversely, if a security's beta is less than 1, it
indicates that the security is less volatile than the
market. For example, suppose a security's beta
is 1.5. In theory, the security is 50 percent more
volatile than the market.
Interpretation of Beta
Sharpe ratio
The Sharpe ratio is a widely used financial metric that helps investors and analysts evaluate the risk-
adjusted return of an investment or a portfolio. It was developed by Nobel laureate William F. Sharpe and
serves as a tool for comparing the potential return of an investment against its level of risk.
The Sharpe ratio quantifies the excess return earned per unit of risk taken. A higher Sharpe ratio indicates
a better risk-adjusted return, meaning that the investment or portfolio is generating more return for each
unit of risk incurred. Conversely, a lower Sharpe ratio suggests that the investment is not generating a
sufficient return for the level of risk involved.
Formula -
Sharpe Ratio = (Rp – Rf)/ σp
Where,
•Rp = Return of portfolio
•Rf = Risk-free rate
•σp = Standard deviation of the portfolio’s excess return.
Let us see the grading threshold of the Sharpe ratio.
1.<1 – Not good
2.1-1.99 – Ok
3.2-2.99 – Really good
4.>3 – Exceptional
Metrics 1, 2, and 3 have a high rate of risk. If the metric is above or equal to 3, it is considered a great
Sharpe measurement and a good investment.
Treynor ratio
•The Treynor ratio is comparable to the Sharpe ratio, which determines the excess return over the
risk-free return per unit of portfolio volatility. This method uses beta as a risk measure instead of
standard deviation. It calculates excess return over the risk-free rate per unit of the investor’s
portfolio beta.
•It measures the additional profits a company could have earned on certain assets based on market
risk. It helps managers make informed investment decisions.
•It assesses portfolio performance by measuring profits. It was named after its inventor, Jack
Treynor. A higher ratio indicates better performance.
Formula
•In the Treynor ratio formula, we don’t consider the entire risk. Instead of that, systematic risk is
considered. Treynor ratio formula is given as:
T = Ri – Rf/ βi
•Here, Ri = return from the portfolio I, Rf = risk free rate and βi = beta (volatility) of the portfolio,
•The higher the Treynor ratio of a portfolio, the better its performance. Therefore, when analyzing
multiple portfolios, using the Treynor ratio formula as a metric will help us analyze them successfully
and find the best among them.
R-squared
✓ R-squared is a statistical measure that
represents the percentage of a fund portfolio or a
security's movements that can be explained by
movements in a benchmark index.
✓ For fixed-income securities and bond funds, the
benchmark is the Treasury Bill.
✓ The S&P 500 Index is the benchmark for equities
and equity funds.
✓ R-squared values range from 0 to 100.
✓ Mutual fund with an R-squared value between 85
and 100 has a performance record that is closely
correlated to the index
✓ A fund rated 70 or less typically does not perform
like the index.
DEFINITION
Asset allocation is a very important part of creating and balancing
your investment portfolio. After all, it is one of the main factors that
leads to your overall returns—even more than choosing individual
stocks. Establishing an appropriate asset mix of stocks, bonds,
cash, and real estate in your portfolio is a dynamic process. As
such, the asset mix should reflect your goals at any point in time.
Asset allocation is an investment strategy that aims to balance risk
and reward by dividing an investment portfolio among different
types of asset classes such as equity, fixed income, cash and cash
equivalents, real estate, etc. The theory is that asset allocation
helps the investor to lessen the impact of risk their portfolio is
exposed to as each asset class has a different correlation to one
another.
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Factors affecting Asset Allocation
[Link] of horizon
Time horizon is the number of months or years an investor is expecting to invest to achieve a
particular goal. Different investment horizons entail different risk tolerance. For instance, a long-
term investment horizon might prompt an investor to invest in a higher risk portfolio as the slow
economic cycles and high volatilities in the market tend to ride out with time.
[Link] tolerance
Risk tolerance refers to an investor’s willingness and ability to lose some or all of their original
investment in anticipation of greater potential returns. Aggressive investors, or investors with high
risk profile are likely to risk most of their investments to get better returns. On the other hand,
conservative investors, or risk-averse investors are likely to invest in securities that preserve their
original investments.
[Link] vs returns
When it comes to investing, risk and returns are inseparably intertwined. The phrase “no pain, no
gain” closely sums up the relationship between risk and reward. All investments hold some level
of risk. The reward for undertaking risk results in higher potential for better returns. 3
Benefits of Asset Allocation
❖ Reduced risk: A properly allocated portfolio strives to lower
volatility, or fluctuation in return, by simultaneously spreading
market risk across several asset class categories.
❖ More consistent returns: By investing in a variety of asset
classes, you can improve your chances of participating in
market gains and lessen the impact of poorly performing
asset class categories on overall results.
❖ A greater focus on long-term goals: A properly allocated
portfolio is designed to alleviate the need to constantly adjust
investment positions to chase market trends. It can also help
reduce the urge to buy or sell in response to short-term
market swings.
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Types of Asset Allocation
Strategic Asset Allocation
This method establishes and adheres to a base
policy mix—a proportional combination of assets
based on expected rates of return for each asset
class. Risk tolerance and investment time-frame of
investor also needs to be taken into account. Client
can set his targets and then rebalance portfolio
every now and then.
A strategic asset allocation strategy may be akin to a
buy-and-hold strategy and also heavily suggests
diversification to cut back on risk and improve
returns.
For example, if stocks have historically returned
10% per year and bonds have returned 5% per year,
a mix of 50% stocks and 50% bonds would be
expected to return 7.5% per year.
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Types of Asset Allocation
Constant-Weighting Asset Allocation
Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in values of
assets causes a drift from the initially established policy mix. For this reason, you may prefer to
adopt a constant-weighting approach to asset allocation. With this approach, you
continually rebalance your portfolio. For example, if one asset declines in value, you would
purchase more of that asset. And if that asset value increases, you would sell it. The goal is to
ensure that the proportions of the asset classes do not deviate more than 5% of the original mix.
Tactical Asset Allocation
Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, one
may find it necessary to occasionally engage in short-term, tactical deviations from the mix to
capitalize on unusual or exceptional investment opportunities. This flexibility adds a market-
timing component to the portfolio, allowing you to participate in economic conditions more
favorable for one asset class than for others.
Tactical asset allocation can be described as a moderately active strategy since the overall
strategic asset mix is returned to when desired short-term profits are achieved. This strategy
demands some discipline, as you must first be able to recognize when short-term opportunities6
have run their course and then rebalance the portfolio to the long-term asset position.
Types of Asset Allocation
Dynamic Asset Allocation
Another active asset allocation strategy is dynamic asset allocation. With this strategy,
you constantly adjust the mix of assets as markets rise and fall, and as the economy
strengthens and weakens. With this strategy, you sell assets that decline and purchase
assets that increase.
This makes dynamic asset allocation the polar opposite of a constant-weighting
strategy. For example, if the stock market shows weakness, you sell stocks in
anticipation of further decreases and if the market is strong, you purchase stocks in
anticipation of continued market gains.
ACTIVE VS. PASSIVE ASSET ALLOCATION
Active asset allocation involves frequent buying and selling of assets in an attempt to
outperform the market. This strategy requires a lot of research and analysis, as well as
active management by the investor or their financial advisor.
Passive asset allocation, on the other hand, involves investing in a diversified portfolio
of assets and holding them for the long term. This strategy is often achieved through
index funds or exchange-traded funds (ETFs), which aim to match the performance of a7
particular market index.
Types of Asset Allocation
Age based asset allocation
This asset allocation strategy takes the age of the investor into account. Under this strategy,
financial advisors recommend subtracting an investor’s age from 100 to determine the
percentage of funds that should be invested in equity mutual funds. The rest should be
invested in other asset classes such as debt. For example, if you are 30 years old, then 70%
of your investments should be in equity funds and the rest (30%) in other asset classes.
Balanced Asset Allocation
Provides a framework to rebalance the portfolio to the ratio of the original asset mix. It
involves selling the securities in the asset class which has appreciated in value and investing
in other asset classes to restore the original asset mix.
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Types of Asset Allocation
Insured Asset Allocation
With an insured asset allocation strategy, you establish a base portfolio value under
which the portfolio should not be allowed to drop. As long as the portfolio achieves a
return above its base, you exercise active management, relying on analytical
research, forecasts, judgment, and experience to decide which securities to buy,
hold, and sell with the aim of increasing the portfolio value as much as possible.
If the portfolio should ever drop to the base value, you invest in risk-free assets,
such as Treasuries (especially T-bills) so the base value becomes fixed. At this time,
you would consult with your advisor to reallocate assets, perhaps even changing
your investment strategy entirely.
Insured asset allocation may be suitable for risk-averse investors who desire a
certain level of active portfolio management but appreciate the security of
establishing a guaranteed floor below which the portfolio is not allowed to decline.
For example, an investor who wishes to establish a minimum standard of living
during retirement may find an insured asset allocation strategy ideally suited to his
or her management goals. 9
DEFINITION
An asset allocation model is a process that helps you determine which investments to choose so
you can diversify the risk of your portfolio. They serve as a kind of guide that emphasizes the
importance of certain securities over others. Each model provides recommendations on how to
best divide your portfolio among the various types of investments that exist.
Because everyone's objectives are different, certain models appeal to some people more than
others. Most models analyze five factors to help you determine which securities to choose,
including:
•Age- Certain investments are better suited for individuals who are older.
•Time horizon- The time horizon describes the time an investor holds a security before selling it.
•Capacity for risk- Capacity risk describes how much risk an investor needs to achieve their
goals.
•Wealth goals- These are the goals that investors have for their financial future.
•Risk tolerance- This metric describes how much risk in the market an investor can tolerate.
Most asset allocation models have dual objectives and balance meeting short-term expenses
while simultaneously growing investments for the future. Splitting goals between short- and long-
term wealth expectations is exactly why some models favor putting more investments in one type
of security over other asset types. 2
Types of Asset Allocation Models
Income model
The income model focuses primarily on investing in
coupon-yielding bonds and dividend-paying stocks. This
type of model usually has minimal risk and encourages
a short to midrange time horizon for potential investors
who choose this approach. Certain dividends, returns
and accounts are taxable under this model. Here are a
few standard ways someone might split their
investments:
•100% bonds
•20% stocks and 80% bonds
•30% stocks and 70% bonds
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Types of Asset Allocation Models
Balanced or Moderate Model-
The balanced model encourages investors to split their investments into
bonds and stocks evenly. Doing this helps to reduce potential security
volatility. Under this model, a portfolio is usually moderate and has short-
term price fluctuations. Investor who follows this model can expect
reasonable financial growth and a mid- to long-term return on their
investments.
Here are a few ways someone might segment their securities:
•40% stocks and 60% bonds
•50% stocks and 50% bonds
•60% stocks and 40% bonds
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Types of Asset Allocation Models
Growth model
The growth model heavily emphasizes the
importance of a portfolio filled mostly with stocks.
The expectation of this model is that stocks are
going to appreciate and provide long-term financial
potential. Because of the focus on stocks, investors
consider the potential of frequent short-term price
fluctuations. This model usually appeals to
individuals with a high-risk tolerance and a long-
term time horizon for their investment. Here are a
few ways that an investor might split their securities:
•70% stocks and 30% bonds
•80% stocks and 20% bonds
•100% stocks
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Types of Asset Allocation Models
Aggressive model
The aggressive model focuses on providing investors with long-term growth instead
of regular income or capital preservation. Individuals who choose this model often
have a high-risk tolerance, allowing them to withstand the substantial fluctuations in
the value of their securities and investments. Similar to the growth model, this
approach emphasizes stock investments and global equities. The time horizon for
their investments is usually long term.
Example:- An aggressive portfolio could be heavily weighted towards stocks, with
90% or more in equities and a minimal allocation to bonds or cash. This approach is
for investors seeking maximum growth potential, accepting higher volatility and risk.
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Types of Asset Allocation Models
Conservative model
The conservative model emphasizes the importance of
modest capital and income growth, with an average
amount of capital preservation. An investor interested in
this approach is usually comfortable with moderate value
fluctuations on their investments and they have a medium-
to long-term time horizon for their securities. This model
focuses on a mix of fixed-income securities and some
equities to achieve a respectable safety net and
performance.
Example:- A conservative portfolio might be composed of
70% or more in bonds and cash, with a smaller portion
allocated to stocks. This strategy prioritizes capital
preservation and income generation, with lower exposure
to stock market fluctuations.
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Types of Asset Allocation Models
Very conservative model
The very conservative model promotes
extreme capital preservation above all else.
An individual who chooses this approach
can usually expect modest growth of their
capital and minor fluctuations of their
investment values. The time horizon for this
model usually has a short- to medium-term
length. Fixed-income securities are the
focus of this model, with a small number of
equities to generate income and safeguard
against the effects of inflation.
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