Chapter 4 “Risk” and “Risk Profiling” in Retirement Planning

Chapter Objectives
 General Definition of Risk
 Concepts on Different Types of Investment Risk
 Subjective Risks and How It Affect Investment Portfolio in Retirement Planning
 Risk Profiling for Gauging the Degree of Risk Acceptable to Clients

Introduction
Risk Defined
For our purpose, we may define risk as “fluctuations or variations in investment return from
expectations with regards to an exposure”. Risk is held to be present in all investment assets.
The exception is the so called “risk-free asset” in portfolio theory.
The investment assets of a client are exposed to various types of investment risk. The major
ones are as follows:
a. Business risk
b. Financial or financing risk
c. Interest rate risk
d. Inflation risk
e. Foreign exchange risk
f. Political risk

Business Risk
- Business risk can be defined as the risk associated with a company’s failure to generate
revenue to cover operating expenses. Essentially, the profit of an organization is
determined by a simple equation where
Profit = Revenue – Expenses
- When revenue falls short of expenses, operating loss will be occurred.
- In general, companies offering essential goods and services will have low business risk
since the demand for such products and services are inelastic. In this regard, companies
providing electricity and water supply with little or no competition have very low
business risk.
- The costs of running a business may be classified into fixed costs and variable costs.
Fixed costs do not change over a given range of production. However, variable costs vary
in accordance with the level of production. A company with very high fixed costs is
deemed to be having high business risk as they require higher volume of sales to
breakeven.
- Companies operating in the IT sector are deemed to have high business risk as the
demand for their products may change vary drastically due to new invention or
substitutions.
- For clients who invest in stocks and shares for purpose of accumulation of retirement
resources, planners should suggest that they avoid counters with high business risk,
particularly when the time to retirement is short. In general, this category of shares should
be avoided unless the clients are very young and have high appetite for risk taking.
Financial of Financing Risk
- Financial risk is a form of risk associated with the usage of external funds in running
the business of a corporation. Perhaps a more appropriate name that should be used
its place is financing risk.
- Usage of external financing involves payment of fixed interest expenses at regular time
interval. An exception is the issuance of zero coupon bonds by business organizations. The
higher the external funds the higher is the fixed interest charges.
- For a company with little or no external financing, financial risk is deemed to be low.
- Companies that have plenty of room for business expansion will usually rely on external
financing. However, the reward to investors can be equally high.
- Financial planner should advise clients to be wary of the even higher risk associated with
companies with high business risk and high degree of external financing.

Interest Rate Risk

- Whenever the central bank of any country is about to make an announcement on interest
rate changes, investors are always cautious to watch for the outcome of the announcement.
This is because such announcements affect the movements of securities.
- An announcement that interest rate is adjusted downward is generally good for the share
market. The reason is not difficult to understand as fixed interest expenses will drop with
the reduction in interest rate; lower interest expenses will mean higher profits to business
organizations.
- Reduction in interest rate is also good for fixed income securities. In investment module,
you would have studied that prices of fixed income securities and interest rates move in
opposite direction of changes in interest rates. Therefore, an interest rate reduction will
bring about increase in prices of fixed income securities.
- While reduction in interest rate will bring about higher prices of shares, warrants and fixed
income securities including preference shares, it is bad for clients and business entities with
a lot of fixed deposits. If the preference is still for fixed deposit as the channel for
accumulation, the planner can advice clients to lock in the FDs for longer tenure up to 5
years in anticipation of interest rate reduction.
- When interest rate is expected to drop, another alternative for clients with low risk
tolerance level is to invest in bonds with fixed coupon rates. In this alternative, the tenure
can be longer or shorter than 5 years to match the investment tie horizon of the clients.
Inflation Risk
- Inflation erodes purchasing power. In general, investors expect rate of return to be high
enough to at least cover inflation rate.
- Otherwise, an open economy may lead to leakage of funds which will eventually lead to
shortage of fund and tight liquidity. In general, central bankers that prefer a stable financial
system will go for a market intervention rate that is higher than inflation rate. All
investment experts and fund managers have their own forecast of inflation rate. This market
perception of inflation rate is one of the factors affecting prices of securities. However,
actual inflation rates announced by the government at a later date may differ from forecast.
In Malaysia, official inflation rate is a hot topic of debate.
- When the actual inflation rate is higher than what had been forecasted, interest rate is
expected to increase. On the other hand, if the actual inflation rate is lower than the
forecast, interest rate is likely to remain low or drop. The effects of these announcements
will therefore affect interest rates, which in turn affect prices of securities as described
earlier.
- Sometimes, investors need not wait for the official announcement of inflation rate. By
monitoring closely, the changes and price adjustment of essential goods that form the
basket of goods chosen to compute the price index, one will be able to form an opinion on
the trend of inflation rate.
Foreign Exchange Risk
- There are business organizations which import raw materials for further processing before
selling to the end users in Malaysia. There are also importers who import finished goods
from overseas for sale in Malaysia. On the other hand, there also corporations in Malaysia
that export goods and service to overseas countries. Most of the imports and exports
between Malaysia and other countries are denominated in US dollars.
- Foreign exchange risk also affects importers and exporters when the ringgit drops.
Lowering of ringgit is good for exporters if exports are contracted in foreign currencies.
However, it is bad for importers as lower ringgit means higher cost of sales and lower
profitability.
- Apart from importers and exporters, some corporations do borrow loans and advances
denominated in foreign countries. For example, a listed corporation in Bursa Malaysia
might have taken a foreign currency loan denominated in US dollar amounted to say
USRM200 million at the time when exchange rate is US1 = RM2.50. This was the rate of
exchange before the Asian Financial crisis. The gross loan proceeds were about RM500
million. However, immediately after the financial crisis, the rate was sell above RM4 for
every US dollar before the ringgit was pegged at US1 = RM3.80. This means that the loan
has increased to RM760 million. The borrower has a foreign exchange loss of RM260
 million as a consequence. Even the burden of interest payment has gone up due to the
weakening of the ringgit against the US dollar.
- Apart from importers and exporters, foreign exchange risk also affect investor with
investment assets denominated in foreign currencies. For illustration, let us assume that
Philip Huang invested RM380,000 in a unit trust scheme that invested funds in US dollar.
At the point of entry, the rate was US1 = RM3.80. The equivalent of the original
investment amount was therefore US100,00. Assuming one year later the investment of
US100,000 has gone up by 10%, the value of investment would have been US110,000. The
amount of US110,000 is then liquidated. Philip Huang may have a profit of RM38,000 if
the exchange rate remains unchanged. Unfortunately, after the de-pegging of the ringgit
with the US dollar, the ringgit strengthened against the dollar. If the exchange rate has
subsequently changed to US1 = RM3.30, Philip Huang will suffer a loss in investment
equivalent to RM17,000 which is computed as follows:
US110,000 x RM3.30 = RM363,000.
Loss in investment = RM380,000 – RM363,000 = RM17,000
Political Risk
- The sovereign right of a government is important when an investor is considering investing
overseas. Political risk refers to the specific rules and regulations by a host government
which affect the continuity of an investment. It can be in form of nationalization,
expropriation and confiscation.
- Political risk in its macro form refers to political change, revolution and adoption of new
policies that affect investment. All foreign investments are therefore affected. In its micro
form, political risk affects the continuity of individual firm or specific industry only.
- Political risk can take place in any country. However, the frequency of happening is higher
in the 3rd World where political instability is much higher. Fund managers will therefore
avoid countries where the political risk are high. However, changes can happen after
investment funds have moved in. Individual investor should sell their foreign funds
whenever macro changes indicate political instability.

Uncertainty is a frame of mind filled with reservations, because of the lack of information of
what will crop up or what will not take place in the future. It is just a psychological reaction to
the lack of knowledge about the future where the probabilities are not established yet.
 Is the Risk Real or Imagined?

- The risk faced by a client can be real or “real” in the mind only. Hence, risk has two
dimensions, the objective and subjective dimensions. When a person faces a risk situation,
he assesses and makes a conclusion of what the risk means to him. The real risk is the
objective risk.
- However, clients often do not view risk in its reality. Their interpretation of the risk
situation may or may not be representative of the true situation but based on their
perception of what the situation is. Because the risk is based on perception of the person,
this sort of risk is known as perceived risk. It is essentially the interpretation of people on
a risk they faced.
- People are influenced by their beliefs, past experiences and value system when they
interpret situations.
 Risk Behaviours
- Everyone is unique and possesses a unique set of attitudes and hence is expected to act in
response differently to a same set of risk stimuli. Some will be more willing to accept high
level of risks in their dealings, while others will act in the opposite manner in the same set
of circumstances.
- Since it is the client’s retirement plan, his attitude towards risk is more important than the
planner’s own. It is precisely because of this, that we must understand the client’s pattern
of thinking towards risk before we finally nail down what is suitable for him. For instance,
you do not recommend risky investments to a ‘safe minded’ person no matter how high is
the yield, and vice versa.
- According to studies made, we can generally categorize people as risk seeking, risk
indifferent or risk averting. The planner must recommend investments vehicles that are
generally in alignment with the client’s type. Let us examine the three types of human risk
behaviour:

 Risk seeking: Risk seekers are those people whose perspective of risk is that it is an
opportunity rather than a threat. Psychologically, they have a partiality for uncertainty to
 certainty in a given state. In addition, they are also likely to underrate risk and have a
preference for variety and ambiguity. It is not unexpected that many successful business
owners possess some or all of these characteristics.

 Risk indifferent: Risk indifferent clients have a “who-care-what” attitude to both the
danger and opportunity presented by a risky situation. They are neither bent towards being
attracted nor being repelled by risk.

 Risk averting: These are people whose viewpoint of risk is a threat. They generally have a
preference for certainty over uncertainty and have a tendency to overrate risk. Hence, they
tend to be pessimistic; focusing on the “loss” aspects of any venture they get involved in.
According to a study made by LIMRA, most people fall under this category is behaviour.

Factors that Affect Rational Thinking

- To understand clients’ risk attitude, we must first of all understand some of the factors that
affect the client’s thinking.
- We know from studies made on human behaviour that people response to and their
assessments of situations is largely driven by what is recorded in the sub-conscious mind.
 And since each has a different recording system in his/her brain, we have to be careful
when making an assumption on what people want to risk.
- Important information surrounding a risk or risk situation could be many. Studies made in
cognitive psychology have shown that individuals are knotty when they have to process
large amount of information. So to arrive at any conclusion, it is necessary to set bounds
and base them on a framework of decision-making.
- Hubert Simon, a Nobel laureate, has described these “bounds” as knowledge, rational
thinking, values and emotions. It is these “bounds” that form the psychological constitution
for decision-making.

 Individual’s Belief and Value System (Religion)

- The real driver of human decisions is the underlying emotion of a person based on this
beliefs and value system. A Muslim will not invest in haram investments no matter what
the returns are. From these examples, we may assume that people are not totally rational
even when making financial decisions of importance. Economist and psychologist term this
behaviour as “bounded” rationality.

 Misjudgement
- We make judgement on a daily basis. However, there is a common tendency for people to
judge inaccurately the degree of risk in a risk situation. This happens mainly due to
overconfidence in personal judgement ability.
- The stock market is a good example of what we are talking about. A lot of losses that take
place in the stock market are due to over confidence and irrational behaviour. When
someone says or thinks he is “sure” of a particular share going up, he tends to ignore the
possibility of wrong information received and plunges in without further checking.
Successes due to pure luck strengthen this overconfidence syndrome.

 Short-Run Trends
- Current trend has a greater impact on how a person reads risk.
- It is easy to be misled by results of short-run trend and view them as results signifying a
long-run trend. This leads to mistakes.
- The law of large numbers works only in long run where the sample base is large enough.
For instance, in the short run, it is possible that the stock market keeps going up and up
without any correction. In the long term, this usually does not happen.

 Misjudging the Scale of the Risk

- It is quite difficult for most people to judge with accuracy the actual magnitude of a volatile
risk. Some of the experiments done on his area have shown that people fail to factor
exposure time correctly into their estimates of the risk.
- There is a tendency to overestimate the force of short-duration high-risk events. People
tend to feel a higher degree of danger than it really is if they are placed in a dangerous
situation for short period of time.
- When the stock market for no reason suddenly takes a steep dip, even though the
fundamentals of the economy are still strong, the market reaction is often not reflective of
the danger posed by the drop.

 Mental Denial of Risk

- Most people who participate in high-risk ventures or activities either do not know the
degree of inherent danger or simply rebuff the likelihood that the risky condition will be
relevant to them personally.
- For instance, those amateurs who constantly go diving in the sea deny that the activity is
risky. The common rebuke is that they are “trained” for the event and hence the risk for
them does not arise. There are also those who deny the existence of risk for them because
they experience good luck in escaping several risky situations. The danger posed by small,
negative probabilities is often denied completely. This attitude assumes low risk is equal to
no risk at all.
 Influence of Bias Attitudes
- Mentally, bias creates selective distortion of the risk faced. Since clients, being human,
cannot be totally objective, it is usual to find them with bias of some kind. Here are some of
the types of bias that you should be aware of.

 Accessibility bias:
- What emerges in the mind as “real” is real to that person. Those events that can be readily
recalled or imagined are often viewed as more real or probable to happen, even when in
fact it does not. Similarly, those incidents that are more blur are treated as less likely to
happen.
- A useful example is the issue of insurance policy claims. Although most claims are paid
without problem, the regular reports in the media and the consumer magazines’ stress on
unpaid claims have created an impression in people’s mind that most insurance claims are
not paid out.

 Intimacy bias:
- Knowledge lessens fear. Those risks that are more closely known to the client are less
dreaded. For instance, most investors have preferred counters. Usually, these are the ones
they are more familiar with and hence, the clients are more willing to invest in these than
other counters new to them.

 Evidence bias:
- What a person believes in, he will have the propensity to try to establish that his beliefs are
right. As such, there is a tendency for people to seek evidence in a selective manner as a
means to support their beliefs. As such, it is natural for them to either distort or ignore
evidence that is divergent to their beliefs.
- For instance, two medical specialists have told a person that he has cancer. He does not
want to believe the specialists and decides to seek a Sin She who will confirm that he is all
right. The evidence given by doctors is ignored despite it is more reliable than that of the
Sin She.

 Illusion of control bias:

- Those clients who have control of a situation will tend to feel they need to feel less fear of
the risk.
- Many people feel it is safer when they are driving than to be a passenger of someone else –
even though the other person has a much better driving record.
Risk Personality
- Observations made by some psychologists have apparently shown that most risk seekers do
not take risk in an appreciably habitual pattern. People choose to take risk only under
selected circumstances, and avoid taking risk in others.
- From their findings, there are essentially four types of life circumstances concerning risk-
taking:
 Money: Risks concerning loss of capital, e.g. business ventures, investments, etc.
 Physical: Risks concerning loss of life, e.g. sky-diving
 Social: Risks concerning loss of face, e.g. singing in a contest
 Ethical: Risks concerning loss of freedom e.g. drug trafficking
- Those who constantly seek out or create risks in all life situations are termed thrill seekers.
This type of personality poses danger to those who are retiring or have retired. It seems
more men than women fall under this group. Thrill seekers generally loathe scheduled
activities and seek experiences that are novel, demanding and multifaceted.
- In investment, they will choose to play “contra” in the stock market even where they have
invested sufficiently with their own funds. They tend to put more value from money earned
 in unsafe undertakings. The constructive outlet for thrill seekers is in activities of art or
science, where they have the liberty and room to be creative. The destructive outlets for
these people are criminal activities.
Risk tolerance
 Risk Tolerance and Demographic Attributes

There have been many studies done on the relationship between risk tolerance and demographic
characteristics such as age, wealth and education. In this section we will briefly explore five key
demographic characteristics of the research done on this topic and taking the local cultural
aspects into considerations.

 Age: As a person grows older, he generally takes less risk. Aging seems to dampen the
spirit of taking on more risk. This observable fact exists in most cultures and races.

 Sex: This is another observable happening. In most cultures, women seem more risk
adverse than their male counterpart, and this is the case across all ages.
  Marital Status: Increased in responsibilities as a result of marriage seems to reduce the
urge to take risk. Those who are not married and have no dependents are generally less risk
adverse than those who are married.

 Occupation: Those working in the public sector are generally more risk adverse than those
working in the private sectors. And within the private sector, those who are owners or part
owners of their respective business are inclined to take more risk.

 Wealth: Wealth increases a person’s risk tolerance. This is true in both absolute and
relative terms. Absolute risk tolerance is the total amount of one’s wealth that is allocated
to risky investments. Relative risk tolerance is measured by the proportion of wealth
invested that a person allocates to risky investments.

Assessing Client’s Risk Tolerance

- Some useful guiding principles should be abided by when weighing up the client’s risk
tolerance. In the context of handling the client’s financial situation, the monetary aspect of
his risk taking character should be the main focus of the planner.
 - In investment planning, it is always better to assume that the client is risk adverse until the
facts indicate otherwise. Do not take the client’s word for granted. People have a tendency
to overstate rather than understate their risk taking inclination. Look out for clients who are
considered risk adverse who are currently losing money. Many in such situations may turn
risk tolerant. In assessing the client, the demographic characteristics must be taken into
consideration. The age, marital status, wealth, etc. can give certain general indications of
the client’s level of risk tolerance.
- Make sure, the manner of communication is appropriate. Communication and interaction
between the client and the planner is essential for a good assessment outcome. In
communicating with the client, keep in mind the type of bias he may have, look out also for
clues, and identify the bias so that you can deal with them appropriately. Look out also for
changing events and situations that may alter the client’s risk tolerant profile. Once an
agreement is reached, it would be good to obtain a written confirmation of the assessment
from the client. This would reduce the possibility that the client may accuse the planner of
recommending products that are not in accordance with his needs and risk profile.

Risk Profile of the Client

- The risk profile of a client is his set of behaviour when he participates in investment.
- It is important to “know the client” in this respect before any investment recommendation
is made. Does he lean away from risk or move towards it?
- It is common for the planner or his practice to draw up a risk profiler consisting of specially
designed questionnaire to help assess the client’s personality and the type and degree of
risk acceptable to him. This is sometimes called risk profiling.
- In professional practice, this is considered a basic requirement when planning for the
client’s investment. The client’s risk appetite must be known before the investment plan is
drawn up.
- A format of the risk profiler is found below.

Client’s Investment Risk Profile Assessment

1. Identify the investment time length (investment time horizon) you are most willing to put
aside your money
a) I am likely to liquidate my investment within the next two years
b) I am likely to liquidate my investment within the next five years
c) I am likely to liquidate my investment within the next ten years
d) I am likely to liquidate my investment within the next twenty years

2. Identify the sort of returns you prefer over a five-year investment period.
 a) 3-5%
b) 5-10%
c) 10-15%
d) More than 15%

3. Which of the following best describes your philosophy in life?

a) Be patient and good things will come your way
b) Analyse any situation before taking action
c) Do first and make adjustment later
d) No venture, no gain

4. Which of the following best describes your attitude towards money?

a) Only buy on cash
b) Always negotiate for a better deal to save money
c) Always be willing to spend first before thinking of returns
d) Maximize your returns by using borrowed funds wherever possible
5. Identify the percentage drop in value of your invested retirement fund within a one-year
period that will make you very nervous.
a) 5% or less
b) 5-10%
c) 10-15%
d) More than 15%

6. Identify the grouping that you feel is the nearest to your attitude towards investment in
general.
a) I am extremely uncomfortable with risk associated with investing
b) I am not comfortable but willing to take some risk investing
c) I am quite comfortable with investment risks
d) I am very comfortable with investment risks

7. Identify the grouping that you feel is the nearest to your attitude towards investment of
funds relating to your retirement.
a) I am panicky watching the fund’s performance fluctuations
b) I am willing to allocate 20% in risky but high return investments
c) I am willing to allocate 50% in risky but high return investments
 d) I am willing to allocate 100% in risky but high return investments

8. Identify which of the following is your likely behaviour if you have won RM1,000 betting
with a friend on a football match.
a) Spend the money in a diner with friends in celebration
b) Save it in the bank
c) Invest the money in the Bursa Malaysia
d) Bet the money won in another football match

9. What would you do when the Bursa Malaysia index takes a sharp swing upwards?
a) Feel nothing
b) Feel happy you had not invested because of the fluctuation
c) Regret for not investing earlier
d) Call your investment broker immediately for advice

10. You were waiting from friends who are gambling in the Genting casino, of which you
are there for the first time. How would you pass your time?
a) Just watch around and wait
 b) Play slot machines or Kino to pass time
c) Play blackjack at the RM25-minimum table
d) Play blackjack at the RM100-minimum table

Answer a: 1 point; Answer b: 2 points; Answer c: 3 points & Answer d: 4 points

Type of Investor indicated by the score
10-20 points: Conservative Investor: You prefer safety in investment
21-30 points: Moderate Investor: You are willing to take some investment risk
31-40 points: Aggressive Investor: You are willing to trade higher risk for a higher return