Topic 7 - Risk Profiling

Question 1

risk

Answer 1

means the possibility of a number of different outcomes resulting from a given action.

Question 2

Risks Your Clients Face

Answer 2

• Inflation
• Liquidity
• Currency
• Economic factors
• Political factors.

Question 3

Clients often think of risk

Answer 3

as the prospect of an undesirable outcome, such as a financial loss or not meeting an investment objective.

Volatility
Broad market
Shortfall

Question 4

Volatility

Answer 4

the fluctuations of investment values over time

Question 5

Broad market

Answer 5

factors that can lead whole markets, or even most markets, to decline together

Question 6

Shortfall

Answer 6

the risk of failing to meet a long-term investment goal

Question 7

What is Risk Profiling?

Answer 7

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

Question 8

The aim of risk profiling

Answer 8

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

Question 9

Risk Tolerance

Answer 9

Risk Tolerance measures how much risk an individual is willing to take

Question 10

Risk Capacity

Answer 10

Risk capacity is the level of financial risk the client can afford to take.

Question 11

Risk capacity has to do with measurable or predictable factors such as client’s:

Answer 11

• asset base
• savings rates
• job and income security
• withdrawal requirements
• time horizon

Question 12

Risk Required

Answer 12

Risk required is the risk associated with the return required to achieve the client’s goals from the financial resources available

Question 13

Separating Risk Tolerance From Risk Capacity

Answer 13

The scores from these risk capacity and tolerance questions are then be merged together into a single ‘score’

This one-dimensional approach attempts to place the client on a single continuum, to calculate a ‘risk score’ to determine ‘optimal’ portfolio for the client

This approach may create a ‘gap’: just because a client can afford to take risk doesn’t necessarily mean they want to or need to

Question 14

Where risk capacity is constrained

Answer 14

investment risk should be commensurately reduced

Question 15

Where risk capacity it is high

Answer 15

the investor may comfortably take on more risk

Question 16

Where risk capacity is neutral,

Answer 16

the appropriate level of risk is determined solely by risk tolerance.

Question 17

A Four Component Model of Risk Profiling

Answer 17

Risk Tolerance
Risk Perception
Risk Required
Risk Capacity

Question 18

Risk Tolerance

Answer 18

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.

Question 19

Risk Capacity

Answer 19

Risk capacity is the level of financial risk an individual can afford to take

For most investors, risk capacity is overwhelmingly more important than risk tolerance

The right level of risk for their investments is far more likely to be constrained by their lack of capacity to cope with capital losses than by their psychological aversion to long-term risk

Question 20

Risk Required

Answer 20

Risk required is the risk associated with the return required to achieve the client’s goals from the financial resources available

Using required returns as inputs to determ ine the investment strategy is often ill-advised

Question 21

Risk Perceptions

Answer 21

Risk perceptions are the unstable, short-term behavioural risk attitudes and willingness to take risk that are exhibited through an individual’s actions.

Question 22

Measuring Risk Tolerance

Answer 22

An individual’s risk tolerance should be assessed using psychometric questionnaires that attempt to uncover stable, long term personality traits

Risk tolerance can be loosely described as the willingness to risk existing assets in order to achieve higher-priority future goals

Assessment of risk tolerance should avoid the measurement of unstable, behavioural short-term willingness to take risks

Question 23

How NOT to Measure Risk Tolerance

Answer 23

• Don’t require finance, investing, or market knowledge
• Don’t require numerical computation or probabilistic reasoning
• Don’t confuse with other risk attitudes, behaviours or investment objectives
• Don’t confuse past behaviours with optimal activities
• Don’t rely on future beliefs or expectation

Question 24

Number of methods by FSP to risk profile

Answer 24

Risk Profile Questionaire
Line Method
Life Cycle Approach
Sensitivity Analysis

Question 25

Consequences of inadequate risk profiling

Answer 25

Client making investments not suitable

FSPs do not have reasonable basis for advice

Question 26

FSPs unlikely to meet obligation by only using a risk profiling tool due to

Answer 26

Risk Profiling tools having limitations
FSPs not educating clients = risk of no informed acceptance
Risk profiling tools identifying gaps. Gaps found should lead to trade off process

Question 27

Differentiate between the traditional measures of risk used by the investment industry, and the average client’s perception of risk.

Answer 27

The investment industry often uses quantitative measures of risk, such as volatility, to evaluate the relative risk of an investment / portfolio.

Clients often think of risk as the prospect of an undesirable outcome, such as a financial loss or not meeting an investment objective.

Question 28

Describe the purpose of the risk profiling process in financial planning.

Answer 28

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.

Question 29

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:

Answer 29

• 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;
• 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.

Question 30

Define each element of the three component risk profiling model.

Answer 30

• 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.

Question 31

Why should financial advisers exercise caution when including risk required in the formal risk profiling process?

Answer 31

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.

Question 32

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

Answer 32

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-timein retirement, should be considered before recommending the client take on additional risk

Question 33

Describe why failing to distinguish between risk tolerance and risk capacity is problematic.

Answer 33

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.

Question 34

How does the evaluation of risk capacity influence the investment allocation decision?

Answer 34

Where risk capacity is constrained - investment risk should be commensurately reduced.
Where risk capacity it is high - the investor may comfortably take on more risk.
Where risk capacity is neutral - appropriate level of risk is determined solely by risk tolerance.

Question 35

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

Answer 35

Risk tolerance is an individual’s stable, reasoned willingness to take risk in the long-term.

Risk perceptions are the unstable, short-term behavioural risk attitudes and willingness to take risk that are exhibited through an individual’s actions.

Question 36

Provide three (3) examples of approaches to measuring risk tolerance which Greg Davies suggests should be avoided.

Answer 36

• Don’t require finance, investing, or market knowledge.
• Don’t require numerical computation or probabilistic reasoning.
• 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.
• Don’t rely on future beliefs or expectations.