“limited words, unlimited thoughts”

  Are you a risk averse or risk loving investor, are generally some of the questions asked by your Wealth Management firm before you go into a Portfolio Investment with them. Is this question in the real sense simple to answer? If you think about it and say you have never had any investment experience before, how would you know what kind of an investor are you? An individual’s attitude towards risk is generally categorized into five types with the mid point being Risk-Neutral. The answer to a certain extent is correlated to what person you are.  Just to clarify things lets set some ground rules. First being the assumption that you are a rational person and a rational person usually undertakes an activity that would maximize his benefit or utility. Second being the asset class for a risk averse investor is usually the risk free instrument. Again in most countries the risk free asset class is usually the Treasury Securities and a retail investor wouldn’t have direct access to a Treasury Security. It would either have to be through a Pension Pool or Mutual Funds. But again the Mutual Fund in turn would carry several risks. So for simplicity sake lets say that the investors choose securities that are almost risk free in nature such as Time Deposits which have insurance. Again lets that there is no limit on deposit insurance and it would be equal to the amount of deposits held. On the other hand the asset classes for a risk loving investor would be equities, real estate, tradable bonds, Futures, Forwards & Options and various non hedged derivative contracts. The investors based on their outlook towards risk would have allocation such as 100% FD’s for the Risk Averse types and 100% equity or its risky equivalent for a Risk Loving types and several other balanced combinations for the other types. Also we are not considering the age factor as age is the natural subsidizer towards risks (with exceptions)  What is being said over here is that the allocation towards risky assets would be in many cases but not all, linked to the kind of risks you undertake in the daily walk of life which would in turn be influenced by your personality type. Now what influences your personality is again a different ball game and there are many theories that have already gone in explaining that. So again what do we mean by personality influencing risk attitude. One of the simplest theories developed describing personality types is by Myers Friedman where he classified personality types based on Type A – who are highly outgoing, very competitive & risk junkies Type B are less competitive and undertake lesser risk and there is the third type which is Type AB. This theory again has its short comings as it does not take into account the several complexities behind a person’s personality. But what it does is gives us a Framework of understanding risk attitudes based on personality types.  So what would we expect from a person who is adventurous, outgoing and loves the uncertainty behind the occurrence of an event and is willing to take a chance? It would ideally be high risk investments, isn’t it? But that again does not mean all sky divers would be equity investors. Whereas some one who like to be sure of an event happening, sees four times left and right before crossing the road doesn’t drive more than 40 miles an hour and is content with what he gets. And of course there would be the balanced types who would be a bit on either side depending on the situation.  This in a very unstructured manner constitutes one of the arms of Behavioral Finance which studies human behavior in context to his investment preferences. So next time your Wealth Manager poses you the question, Are you risk averse or a Risk Loving investor and if you have no clue what to say then just sit back and asses yourself about what you have done so far and the manner in which you have and you will have a better understanding about the portfolio that would best suit your personality type.