Significance of Correctly Answering Risk Tolerance Questionnaires
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A risk tolerance questionnaire assists investors in understanding their outlook on investment opportunities. It also provides them with knowledge of financial markets and the economy. Financial planning is a complex task, which requires complete and correct details to arrive at suitable investment decisions for every individual. Apart from other information, one of the most important aspects of data collection is gathering facts about the investor’s capacity to absorb risk. It is imperative to understand the investor’s aptitude for risk tolerance as this plays a significant role in drafting the investment plan.
Thus, investors are required to answer the risk tolerance questionnaire with utmost clarity and honesty. A risk tolerance questionnaire captures the investors’ ability to endure losses when their portfolio performs poorly. This endurance level further decides the composition of their portfolio, suitable to meet both short-term and long-term goals.
Components of a risk tolerance questionnaire
The questionnaire endeavors to understand various factors associated with an individual’s experience, knowledge, expectations, and risk-absorbing capacity. Here are some components of risk tolerance questionnaires:
- An individual’s experience in the field of financial investment.
- An investor’s awareness and know-how of investment and financial markets.
- The level of risk taken by an investor in past investments (if any).
- An individual’s attitude towards risk.
- A person’s capability to make investment decisions.
- The frequency of tracking the performance of a sizable investment that is highly volatile.
- A person’s attitude towards a portfolio comprising largely of stock market investments.
- The more significant option for the individual between safeguarding an investment with the minimum decline in value and making profits with investments in volatile funds.
- Lastly, the most probable response towards a fall in the stock market, when an individual has strongly invested in shares.
Financial advisors calculate a score based on these answers. The total score then puts the client under different categories depending on the level of risk they are ready to bear. Investors must reply to each question with complete transparency, for an accurate analysis of their investment portfolio.
Risk tolerance categories
Based on the score attained in the risk tolerance questionnaire, investors can fall under five probable categories:
- Risk hesitant: These investors are not interested in taking any risk, even if it results in low profits. Their primary purpose is the protection of their investment. They are willing to give up high returns that can be earned through investment in volatile financial instruments.
- Conventional: These people have a more conventional attitude towards taking a risk. This implies that while they are comfortable with allowing marginally risky investments, they will always prefer safeguarding their investments rather than seeking higher risks.
- Reasonable: These individuals are ready to adopt a more balanced approach. Their portfolio will be equally distributed among high-risk and low-risk investments.
- Augmentation: These investors are biased towards making profits through investment in long-term opportunities. They are willing to take a risk if the opportunity displays a strong possibility of high return and growth in the long run.
- Aggressive: These investors are well equipped with the know-how of market and investment mechanisms. They have a high tolerance for risk and are therefore willing to put aside investment security to earn maximum possible profits in the future.
Significance of Honest Answers
The truthfulness and accuracy of an investor’s answers can help them move forward in their investment journey. Here’s why it is important to maintain honesty:
Optimum asset allocation
Risk assessment allows the financial advisor to allocate the investors’ funds optimally. The investment is made in line with the risk associated with certain assets and the level of risk which the investor has decided to undertake. In case of incorrect answers, the investor can land up with a portfolio that is either too risky or less risky than their real absorbent capacity. This, in turn, can affect their returns. If the assessed risk is less than the actual aptitude, then the investor can end up losing out on higher returns, since a higher risk portfolio might have earned more profits in the long run.
Possible reactions to future scenarios
Investors need to understand their reaction to the volatility of the market. If an investor believes he is not risk-tolerant, but the incorrect answers in the questionnaire suggest otherwise, then the investor might face some unexpected setbacks. An individual with a low-risk aptitude will not be able to handle a drop in the market if his funds are invested in shares that involve high-risk. A sudden bear market can bring unexpected repercussions for such investors.
Achieving investment goals
Every investor has a different expectation from their financial portfolio. Some are looking for retirement, while others want to receive returns in the short-term. Given the risk tolerance level of an individual, the financial advisor will accordingly formulate the portfolio to ensure that the person’s needs are met. Any evasive answers in the questionnaire will alter the acceptable risk level, thereby affecting the portfolio composition. This, in turn, will adversely affect the ability of the investments to meet their ultimate needs.
Stage of life
The ability to take risk depends strongly on the age of the investor. If a person is nearing retirement, they may not be in a very strong position to take high risks. The questionnaire must be answered, keeping in mind the age and the financial background of the individual. Incorrect answers might lead to higher risk investments, particularly for elderly investors who may not be able to afford them. It might also result in a loss for younger investors who may forgo opportunities with higher risks and returns.
The primary purpose of any investment is the enhancement of existing wealth for future use. The correct risk tolerance assessment is instrumental in the formulation of a portfolio that might allow the investor to earn the funds required by them, at the time of need. Incorrect information can mislead the asset compilation, where investors might fail to meet their financial requirements, which were their main reason to invest.
To sum it up
Formulation and assessment of risk tolerance questionnaires are imperative for preparing an optimum investment plan for investors. Thus, it becomes extremely essential for individuals to answer the questionnaire truthfully. This honesty can go a long way in helping them meet their short-term and long-term financial needs, along with maintaining their risk appetite. Investors can also gain a more unobstructed view of what their asset portfolio must consist of, allowing them to make more sound financial decisions.
Along with being open and honest in the questionnaire, it is also important to consult a knowledgeable, professional financial advisor.