Risk Profiling: The Regulatory Requirement Before Advice

Advice that takes somebody's circumstances into account has to establish those circumstances first, so risk profiling is the step a firm completes before it advises a person. The Securities and Exchange Board of India (SEBI) names a documented process in its investment adviser regulations at sebi.gov.in, read on 18 August. The categories a firm maps answers to are the firm's own written policy rather than a regulatory table.

Underneath the requirement sits a distinction most people run together, and separating it is the whole of the exercise. How much loss a person's finances can absorb is arithmetic about money that already exists. How much loss the same person can sit through without doing something they later regret is temperament. How much risk their objective actually demands of them is a third thing again, and it answers to neither of the first two. A profile that collapses those three into one number has thrown away the disagreement between them, and the disagreement is the useful part.

Take an ordinary household for a moment, before any of the vocabulary arrives. A household running a small sweet shop has a good year and puts something aside. On paper they could lose a chunk of it without the shop closing or a single bill going unpaid. The finances are the first measure. But the wife has watched her father lose a shop, and the first month of falling numbers keeps her awake, so the money comes out at the worst possible moment. The temperament is the second. And the daughter starts college in three years, a fixed date that neither the arithmetic nor the sleeplessness can move. The date is the third. Three honest answers, three different directions, one household.

Risk profilingThe documented process of establishing a person's circumstances, and their attitude to loss, before advising them. is the process that gets all three of those on paper before anybody says a word about what to do with the money. The process itself, the record it has to leave and the limits of what a finished profile establishes are set out below, as the requirement stands in India.

Why is profiling a requirement rather than something a careful firm does anyway?

Because the thing being regulated is advice, and advice that is described as suitable for a person is a claim about that person. A firm making that claim has to be able to show what it knew when it made it. If the enquiry into the person happens after the recommendation, or in somebody's head, or not at all, then the word suitable in the file is decoration. So the requirement runs in one direction and only one: the enquiry first, the advice afterwards, and a record of the first that can be read on its own.

The regulator turned a good habit into a precondition precisely because a good habit is invisible on the day somebody asks what happened. Two advisers can be equally conscientious, and only one of them can prove it eighteen months later. The difference is not in the two advisers. A conversation leaves nothing behind. A process leaves a document with a date on it. Kamala Ravindran, who founded Sarvodaya Capital Advisors Private Limited, an invented nine person firm in an unnamed Indian city, puts it to new joiners in one line: nobody will ever ask an adviser whether they thought about it, they will ask to be shown where it was written down.

What does a documented process contain, and why is documented the operative word?

Documented is the word doing the work, and it is worth being blunt about why. An undocumented process is indistinguishable from no process, not because anybody is assumed to be lying, but because there is nothing to look at. So a process that satisfies the requirement has parts a reader can point to, and each part is a thing that exists on paper rather than a quality somebody has.

Five things sit on that record, and any one of them missing breaks it. The questions that were asked. The answers the person gave. The written policy that was in force on that date, meaning the firm's own document saying which combination of answers maps to which output. The categoryThe output band that a firm's own written policy maps a set of answers to. The label is the firm's, not the regulator's. that followed from applying that policy to those answers. And the date. Take away the policy that was in force and there is no longer anything the answers can be checked against, so the category becomes an assertion nobody can check.

Devaki Suresh is the compliance officer at Sarvodaya Capital Advisors Private Limited, and the version control on field three is hers. The firm's mapping document carries a version number and a date on every printed sheet, and when it changes, the old version is kept rather than replaced. The habit sounds like clerical fussiness until what it buys becomes clear: a file from two years ago can be read against the policy that existed two years ago, instead of against the one that exists now. A firm that overwrites its own mapping policy has destroyed the only reference against which its old files could ever be read.

Capacity: what can the household's finances absorb without the plan failing?

CapacityHow much loss a person's finances can absorb before the thing the money was for stops being achievable. is arithmetic, and it is the least emotional of the three. Capacity asks what already exists: what comes in, what goes out, what is committed, what is borrowed and on what terms, how many people depend on the income, and how soon the money in question is actually needed. None of that is about how anybody feels. Two households with identical temperaments and different balance sheets have different capacities, and the difference is not a matter of opinion.

The Bhoite household, Sarvodaya's invented advisory client, is one salary, two dependants and a home loan running. Every one of those four facts is a capacity fact. The single salary means there is no second income to absorb a shock. The two dependants mean the outgoings have a floor under them. The loan means a fixed monthly obligation that does not care what any market did last quarter. A loss with fifteen years to recover from and a loss with three years to recover from are not the same loss, so the timing of when the money is needed sits inside capacity too. Capacity is entirely about what the money has to do and by when, and it can be worked out on paper without asking the person how they feel about anything.

Willingness: what can a person actually sit through, which is not the same thing?

WillingnessHow much fluctuation a person can actually tolerate without acting on the discomfort. is temperament, and it is measured by asking rather than by calculating. Willingness is what a person says about falling numbers, what they have done before when numbers fell, and how they describe the experience afterwards. Temperament is not a moral quality and it is not a competence. Some people watch a bad quarter with genuine equanimity and some do not sleep, and neither of those is the correct way to be.

Willingness is where the dignity of the whole exercise sits, so it is worth being direct. A person whose stated willingness turns out to overstate what they could actually sit through has not failed a test. The person answered a question about a loss they had not yet experienced, in a calm room. A calm room is the only condition under which the question can ever be asked. Willingness is a statement about an imagined loss, and an imagined loss and a real one are different experiences for almost everybody. The process records the statement. The record does not pretend the statement is a prediction.

Need: how much risk does the objective itself demand?

NeedHow much risk the person's own objective requires them to take, given the sum, the time and what is already there. is the measure people forget, and it is the only one of the three that comes from the objective rather than from the person. Need asks what the money has to buy, how much of it is required, by when, and how much is already there. Out of those four falls an answer about how hard the money has to work, and therefore how much variability the plan has to accommodate to have a chance of getting there.

Need is the awkward one because it can point in a direction neither of the others likes. A household with a large sum already set aside for a purpose may need to take very little risk at all, whatever their capacity or their appetite. A household with a distant objective and very little set aside may find that the objective itself demands more variability than either their capacity or their willingness would support. The finding is not a fact about their character but about the arithmetic of the objective. When need exceeds what capacity and willingness can carry, the honest output is a conversation about the objective, not a higher category.

Where do the three disagree, and why is that disagreement the useful part?

The three readings for one household, set on a single scale, stand at a distance from each other. The distance is not noise in the process and it is not something to be averaged away. The distance is the finding. A household whose capacity reads high and whose willingness reads low has established something specific: the money could take a fall, and the person probably could not, so anything built on the arithmetic alone is likely to be abandoned at the worst moment by the person who has to live with it.

The average describes nobody and the disagreement described somebody exactly, so the single most common damage a profiling process does is to average three disagreeing readings into one number. Sarvodaya's own written policy keeps the three separate on the face of the record for that reason, and the mapping to a category is applied on top of them rather than instead of them. The three readings survive on the record, so a later reader can see not only what the category was but what the three inputs were doing when it was produced.

How does an adviser actually use the gap, on an ordinary Tuesday?

A measure nobody uses is a measure nobody should have taken, so the practical part matters. An adviser sitting with a household reads the three lines and starts with the widest gap, not with the highest number. If capacity is well above willingness, the discussion is about what would actually happen in a bad six months: who would ring whom, what would be sold, and what the household would want somebody to say to them at that moment. The discussion produces a written note, and the note goes into the file beside the three readings.

If need sits above both of the others, the discussion is about the objective instead: whether the date can move, whether the sum can change, whether something already set aside can be brought to it. The gap tells the adviser which conversation to have, and having the right conversation is the only thing the three separate readings were ever for.

A lender does something structurally similar with a borrower, and the shape is worth noticing because it is not peculiar to advice. A lender assesses what the household can service from income, and that assessment is capacity. The lender then assesses separately what the household says it intends to do, and the second answer is not the same evidence and is not treated as if it were. Nobody in a lending office averages those two into a single figure and lends against it. The two are held apart precisely because they can disagree, and the disagreement is information.

Where does the category mapping come from, and whose document is it?

The mapping is the part of the subject that matters most, and it is the part most often misread. The requirement is that the firm has a documented process and applies it. The mapping inside that process, meaning the specific rule that turns this set of answers into that category, is the firm's own written policy. No regulator publishes that mapping, and it is not the same across firms. The requirement fixes that a written mapping exists and is applied, not what the mapping says, so two honest firms can map identical answers to different categories and both be running a documented process.

The firm's ownership of the mapping has a direct consequence for the file, and it is the reason field three on the record exists. If the mapping belongs to the firm, then reading a category two years later establishes nothing unless the mapping that produced it is sitting next to it. A category is the output of a function, and a function nobody can see is not something anybody can check.

Once the mapping is accepted as a written document with boundaries somebody chose, a second thing follows immediately, and it is uncomfortable. Any boundary has two sides, and answers land on both of them. Sarvodaya's own policy maps one of its questions like this: how many years until the money is needed. One to three years is Band A, four to nine years is Band B, and ten years and beyond is Band C. The letters are labels in one firm's internal document and nothing more. On their own the letters mean nothing about anybody's money: each is an output of one firm's internal mapping and carries only what that mapping puts into it.

The two readings sit a single year apart. At four years the answer sits in Band B, one year above the boundary, and at three years the same household with every other answer unchanged sits in Band A. One year of difference in one answer, and the output label changes. Nothing about the household changed between those two readings except a date. The step is not a flaw in Sarvodaya's policy, and drawing the boundary somewhere else would not remove the problem, it would only move it. Every written mapping has boundaries, and answers land beside them. A careful firm writes a note rather than adjusting the answer, so the file shows that somebody saw the boundary and recorded what they did about it.

What makes a profile stale rather than wrong?

A profile can be perfectly correct on the day it was taken and useless eighteen months later, and that is a different failure from being wrong. Wrong means the process was misapplied or the answers were not really the person's. StaleA profile that was accurate when it was taken and no longer describes the person, usually because their circumstances moved. means everything was done properly and the person has since changed. A profile ages by events rather than by the calendar, so a two year old profile can be entirely current and a two month old one already stale.

Ageing by events is the reverse of how most people think about a document going out of date, so it is worth being concrete. A household whose income, dependants, borrowings, objectives and horizon are all exactly as they were two years ago has a profile that still describes them. Nothing has moved. A household that had a child, changed employer, took on a loan or brought an objective forward by two years last month has a profile that no longer describes them, however recently it was signed.

What triggers a fresh profile?

A life eventA change in a person's circumstances that can move their profile without any change in their temperament. triggers one, and the list of what counts is the firm's own written list, kept with the mapping policy. The recognisable ones are a change in income or in employment, a birth or a death in the household, a marriage or a separation, a new borrowing or the closing of an old one, an inheritance, a serious illness, and an objective moving nearer or further away. Not one of those is a change in temperament. Every one of them can move a category.

There is a second trigger that is easy to miss, and it is the firm's own document changing. If the mapping policy is revised, every profile produced under the old version was produced by a function that no longer exists. A revision does not make those files wrong, and it does not automatically make them stale either, but it does mean the version stamped on each file is the only thing telling a later reader which function produced it. One half records changes in the person and the other records changes in the firm's own rule, so the trigger list and the version history are two halves of the same discipline.

What did the second profiling of the Bhoite household actually change?

Sarvodaya Capital Advisors Private Limited profiled 148 clients in one year, an invented figure and the firm's own. 12 of those 148 were profiled again during the year because a life event had landed, and 4 of those 12 came out in a different category. Four out of twelve is a third of the re-profiled group, and that last count is the one worth dwelling on. The counts belong to Sarvodaya alone and are not a rate anybody should expect anywhere else. For scale, Sarvodaya is a nine person firm with paid up capital of Rs 25,00,000 and net worth on its application date of Rs 62,00,000, neither of them compared against any eligibility figure. The eligibility figure lives in the regulation and is read there.

The Bhoite household is one of the four. At the first profiling there was one salary, two dependants and a home loan running, and the answer to when the money was needed was four years. Between the two profilings the household's circumstances changed and the objective came forward by a year, so at the second profiling the same question was answered three years. Their willingness reading did not move at all. The same household, the same person answering, the same words about what a falling market would feel like. Capacity moved because the circumstances moved, and the category followed the capacity. Following the capacity is exactly what a category is supposed to do.

What record does profiling leave, and who reads it back?

The record is the suitability recordThe file showing why a particular recommendation fitted a particular person, on the date it was made., and it is read back at one moment: when somebody is asking why that recommendation was made to that person. The reader might be a regulator, a court, the client themselves, a client's son going through their late father's papers, or the firm's own compliance officer sampling files. Whoever it is, they arrive with no memory of the meeting and only the paper.

The reader needs something small and specific. The answers the person gave. The mapping policy that was in force on that date. The category it produced. The dates. And, where the answers landed near a boundary in the mapping, the note somebody wrote about it. With those in the file the recommendation can be assessed against what was known at the time. Without the mapping policy there is nothing to assess the category against, so it cannot be assessed at all. Devaki Suresh keeps the record inventory at Sarvodaya. The inventory holds 7 categories of record across roughly 1,480 filed records a year, both Sarvodaya's own counts, and the profiling files are one of those categories.

What does a risk profile not do?

A risk profile does not predict behaviour under an actual loss. A profile records a stated position, given in a calm room, about an event that has not happened. The stated position is genuinely useful and it is not the same thing as knowing what somebody will do when their savings fall and the news is loud and a relative is telling them to get out. A person whose reaction to a real loss turns out to differ from what they said in the room has not been caught out, and nothing about that outcome makes them foolish. The person answered honestly about something they had not yet lived through, and honest answering is the only way that question can ever be answered.

Nor does it decide anything. The category is an input to a decision that a person and their adviser still have to make, and the process that produced the category does not make it. A category also does not describe the person. Band A is not a personality, it is the output of a written function applied to a set of answers on a date, and the same person answering the same questions with a different objective in mind can land somewhere else without having changed at all.

And it does not stay true. Everything the profile records is a snapshot of circumstances that will move, and the triggers and the re-profiling discipline exist for that reason. The honest description of a risk profile is a dated record of what was established and how, and every claim beyond that is something people have added to it.

Sarvodaya Capital Advisors Private Limited, Kamala Ravindran, Devaki Suresh and the Bhoite household are invented.
Educational material. Not advice on any investment, tax, budget or market position.