Futurist Edge: Practice Management

Is your risk profiler 3-D or still uni-dimensional?

Futurist Edge's Practice Management column seeks to get you up to speed with the latest insights and developments in the exciting and ever evolving world of advisory practice management. To be future ready, you need to embrace what looks like cutting edge thinking today, but which may well become common practice in future. You need to gain that edge - with the Futurist Edge.

A lot of thinking has gone in recently into one of the most underutilized and abused advisory resources - the risk profiler. It is perhaps underleveraged because the conventional uni-dimensional risk profiler offered little value to the investor and the advisor - and largely served to complete a compliance process. Modern thinking on risk profilers, backed by studies on efficacy of conventional risk profilers, has now seen the introduction of a three dimensional approach to risk profiling, which now serves as an invaluable advisory tool. Is your risk profiler still a uni-dimensional one, or have you moved with times to give your practice a cutting edge?

Conventional uni-dimensional approach to risk profiling

Product suitability - the process of recommending investments that are suitable to the individual investor - is the bedrock of financial products intermediation, whether you call it distribution, advice or wealth management. The most widely used tool to assess product suitability is a risk profiling questionnaire. Some say it is also the most abused tool, as it has often been found woefully inadequate in ascertaining product suitability. What are the inadequacies of a standard risk profiling questionnaire and what can you do to make your risk profiler a valuable input in guiding your clients?

A typical questionnaire covers questions regarding age, stage of life, knowledge and experience of investments, time horizon of investment, purpose of portfolio, level of comfort with fluctuations. Based on the answers, the client is rated as a conservative investor, balanced investor, growth investor or an aggressive investor. Investments made on the basis of such a profiling exercise have often found to be sub-optimal, leading to a poor investor experience.

What's missing in this conventional approach is that it is uni-dimensional - it assesses only one aspect which is the risk appetite of the investor. Modern day risk profiling has moved from a uni-dimensional approach to a three dimensional approach.

Modern day 3 dimensional approach to risk profiling

The 3-D approach to risk profiling can be depicted as follows:

Risk appetite

Risk appetite, which is at the top of this pyramid, is what is used in conventional risk profiles. It assesses the individual's risk appetite - his stated ability to withstand market volatility and the time horizon he has available to help him weather volatility in the quest for higher returns.

Risk tolerance or risk appetite differs from one individual to another and is a reflection of both personality and life experiences. It is not a reflection of markets or financial circumstances but a psychological attitude towards risk and the person's ability to handle risk. It is largely settled by early adulthood. Risk tolerance does decrease slowly over time and may be changed by life events like marriage and having children, but otherwise is stable even through financial market highs and lows.

The appetite for risk is not the same across all spheres of a person's life. An adventurous person, who loves mountain climbing and traveling to exotic locations, may not like to take huge financial risks. Conversely, someone who lives a very modest lifestyle may be willing to gamble on higher-risk investments.

There are two other dimensions which are equally important, which many risk profiling questionnaires do not adequately address.

Risk capacity

Risk capacity refers to the financial ability of the individual to stomach market volatility. An individual with large outstanding loans would get a lot more concerned when market volatility hits his portfolio, than a debt free investor. An investor for whom this financial portfolio represents a very large portion of his overall net worth, will have a lower risk taking capacity, even if his risk appetite shows him as a growth/aggressive investor. If the answers in the risk appetite questionnaire indicate an "aggressive" investor, but you find out through more probing that his risk capacity is low, you would, as a responsible advisor, guide him towards a risk profile that considers both aspects - risk appetite and risk capacity. That's what would probably give "suitable" investment solutions.

Risk required

Risk required is a dimension that is addressed in a financial planning proposition, but tends to get left out otherwise. Whenever you opt for a goal based sales process, you quantify the goal, you consider savings - present and future that the investor can allocate towards this goal and come up with a required run rate - a required rate of return to help match the investments and the desired outcome. This required run rate comes with a level of risk associated with it. To achieve for example a 13% CAGR over 10 years, you will need to have a large equity component in the portfolio. Now, if the risk appetite of this investor suggests a "conservative" investor, how will you then proceed with recommending a "suitable" investment solution?

This is where you would typically help your clients understand risk better. You will help them understand that opting for a "safe" investment in the fear of market volatility can entail much larger financial risks down the road for them, as compared to mitigating market volatility related risks through systematic investing and long term horizons. In short, you will try to help your client arrive at a risk profile that optimizes all the three dimensions - risk appetite, risk capacity and risk required.

Insights from international studies

International studies indicate that risk capacity is often poorly covered in questionnaires. While risk appetite is where most conventional questionnaires focus, there are some gaps noticed, which studies have pointed out. Here are some of the salient findings of various studies done in different markets:

1. While most advisers ask about the clients' prior investment experience, there is a tendency to overlook the clients' education level and profession. This is important because studies indicate a link between education and financial capability with regards to choice of investment products.

2. Questions used to assess customers' investment knowledge and experience have been found to be poorly constructed and use too complex language or are vague. The questions may not accurately verify that the client understands basic notions like the relationship between risk and expected return and portfolio diversification.

3. While questions regarding the clients' personal income and assets are covered, some advisers do not look closely at the clients' ability to finance the investments. Advisers often do not gather information about the clients' existing financial commitments, as well as regular transactions and expenditures.

4. Studies also show that there is a gap with the types of questions asked by the advisers to establish the clients' risk profiles. More than 60% of clients were queried on their risk-return preferences but only over 30% were asked about their ability to deal with investment risk. Many advisers fail to take account for the clients' psychological ability to take losses and fail to identify clients that are unwilling to accept any risk of capital.

5. Questions related to establishing the risk appetite of the client are often left to the interpretation of the advisors and this may be affected by their potential bias. Those who work in the financial industry are generally more risk aggressive and interpreting the result based on their own risk attitudes may result in an incorrect client profile.

6. Advisers often overestimate the risk tolerance of male clients and underestimate the risk tolerance of female clients. Data shows that men are more risk tolerant but the difference between female and male risk tolerance is marginal.

Next steps for you

As a Futurist, you would want to use contemporary risk profiling tools that help you better achieve your objective of recommending investment solutions that are genuinely "suitable" to your clients. The most futuristic of these tools are psychometric testing tools, which will be covered in the next article of this series. But, even if you are not likely to use psychometric tests, you may want to review the current risk profiling questionnaire that you are using, and see whether it adopts a 3-D approach as suggested here or is still pretty much a uni-dimensional one. If it has not yet upgraded to a 3-D approach, use the insights from this article to make it more contemporary, more relevant, and more useful to your clients and to you.

Content is created by Wealth Forum and must not be construed as an opinion by DSP Blackrock MF.

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