Risk Profiling (Seminar 7) Flashcards
Differentiate between the traditional measures of risk used by the investment industry, and the average client’s perception of risk.
The investment industry often uses quantitative measures of risk, such as volatility, to evaluate the relative risk of an investment / portfolio. Our training in finance and economics emphasises the importance of considering the effects of economic factors (such as economic growth, inflation, employment, exchange rates, interest rates and business sentiment) and political factors (such as changes in government, political uncertainty and international conflicts) on investment performance.
However, clients rarely think in terms of narrow mathematical definitions of risk. Clients often think of risk as the prospect of an undesirable outcome, such as a financial loss or not meeting an investment objective. Advisers should consider taking a more comprehensive approach to educating their clients about the nature of investment risk, as well as understanding their clients’ true and complete risk profile.
Describe the purpose of the risk profiling process in financial planning.
Financial Service Providers that provide personal financial advice to retail clients are obliged to ensure the financial products they recommend are suitable having regard to each client’s objectives, financial situation and needs. An important part of the assessment of a client’s objectives, financial situation and needs is the knowledge of the client’s tolerance to risk. The aim of risk profiling includes obtaining a client’s informed acceptance of their risk profile and the possible investment implications that may arise from the outcome of the risk profiling process.
In the article ‘Risk profiling in financial advice disputes, the Financial Ombudsman Service (FOS) (now part of the Australian Financial Complaints Authority) explains its approach when determining whether risk profiling practices and procedures are adequate. Other than an awareness of the limitations of risk profiling tools, what other recommendations does FOS provide in determining whether a financial services provider’s risk profiling practices and procedures are adequate?
When investigating the adequacy of risk profiling practices and procedures, FOS considered the Financial Service Provider’s practices and procedures as a whole. This is
likely to include a consideration of whether the FSP has:
• addressed the inherent and specific limitations in the risk profiling tool used;
• risk profiling practices and procedures that address both the client’s attitude to risk and
capacity for loss;
• determined the risk profile for each spouse or partner;
• determined the risk profile of the client in each of the capacities the client acts (e.g. as an individual, in the client’s capacity as a trustee of a SMSF or company director etc);
• conducted a transparent risk / reward trade off where clients do not have sufficient financial resources to meet their stated objectives in the timeframe they have identified and having regard to their stated appetite for risk;
• sought to actively understand their clients’ concerns and objectives; and,
• sought to educate their clients about risk and reward.
Define each element of the three component risk profiling model.
The three component risk profiling model suggests that the optimal level of investment risk for your client requires balancing their risk required, risk capacity and their individual risk tolerance.
• Risk Tolerance is generally defined as the level of financial risk the client is willing to take. Some individuals find the prospect of investment volatility and the chance of losses distressing. Others are more relaxed about those issues.
• Risk capacity is the level of financial risk the client can afford to take.
• Risk required is the risk associated with the return required to achieve the client’s goals
from the financial resources available.
Why should financial advisers exercise caution when including risk required in the formal risk profiling process?
There is often a mismatch between risk required, capacity and tolerance. An adviser may, based on the client’s current circumstances, feel it is necessary to increase their exposure to risk in order to achieve their stated financial goals.
However, the risk required may be unreasonable or unrealistic, or may be incompatible with the clients risk capacity and risk tolerance. Advisers need to be careful to not project their own risk tolerance on their clients, and recommend a significantly higher level of investment risk than the client is comfortable with.
Suggest possible alternatives to recommending a client take on additional risk, where a client’s risk tolerance and risk capacity are inconsistent with their risk required to achieve their financial goals.
When a mismatch between risk required, capacity and tolerance is discovered, there are a number of trade-off decisions that should be discussed with the client. Decisions like delaying retirement, spending less (or earning more), or working part-time in retirement should be considered before recommending the client take on additional risk
Describe why failing to distinguish between risk tolerance and risk capacity is problematic.
The one-dimensional approach to risk profiling attempts to place the client on a single continuum by merging together responses to risk capacity and risk tolerance questions into a single ‘score’.
By merely averaging together risk tolerance and risk capacity scores, the advisor can unwittingly end up in situations where clients with extremely low risk tolerance (or risk capacity) end up with portfolios that are far too risky for their situation.
How does the evaluation of risk capacity influence the investment allocation decision?
Where risk capacity is constrained - for example, due to large near term expenditures or withdrawal requirements, or where the investor has little future income to rely on as retirement approaches - investment risk should be commensurately reduced.
Where risk capacity it is high - for example, early in life where investors have many years of anticipated net saving ahead - the investor may comfortably take on more risk.
Where risk capacity is neutral, the appropriate level of risk is determined solely by risk tolerance.
Recent advances in risk profiling seek to distinguish between an individual’s risk tolerance and their risk perceptions. Distinguish between these two dimensions, and explain why distinguishing between these two concepts is important.
Risk tolerance is an individual’s stable, reasoned willingness to take risk in the long-term.
Stated differently, it is a measure of an individual’s willingness to risk existing assets in order to achieve higher-priority future goals.
Risk perceptions are the unstable, short-term behavioural risk attitudes and willingness to take risk that are exhibited through an individual’s actions.
It is not the goal of risk profiling to optimize for these sorts of behavioural responses to risk.
Provide three (3) examples of approaches to measuring risk tolerance which Greg Davies suggests should be avoided.
- Don’t require finance, investing, or market knowledge. Otherwise you are not testing tolerance, you are testing knowledge.
- Don’t require numerical computation or probabilistic reasoning. Otherwise you are testing their level of numeracy, and how they feel about those numbers today.
- Don’t confuse with other risk attitudes, behaviours or investment objectives. e.g., mixing tolerance with time horizon (i.e., capacity).
- Don’t confuse past behaviours with optimal activities. i.e., don’t assume that past behaviour is how the client should or would want to act in future.
- Don’t rely on future beliefs or expectations. What our clients think equity markets will do in the future should not influence our recommendations.
Briefly summarise the approach taken by Vanguard UK (2012) when developing their risk tolerance questionnaire.
• Based on an Attitude to Risk questionnaire by Byrne & Blake
• Builds on established psychometric principles and represents best practice from
the science of measuring an individual’s willingness to take risk.
• Avoids questions that present complex investment scenarios, require mathematical calculations or use concepts such as percentages
• Avoids vague questions, or those that deal with issues that people outside the industry might not know anything about
• Each question contains only one question or statement and avoids subjective words like ‘frequency’ whenever possible.
• Initial screening test on 141 individuals used to remove difficult/irrelevant questions and ‘outlier’ questions which did not correlate with the overall index
• Test scores were ‘normalised’ to aid interpretation
