Topic 7 - Risk Profiling Flashcards
risk
means the possibility of a number of different outcomes resulting from a given action.
Risks Your Clients Face
- Inflation
- Liquidity
- Currency
- Economic factors
- Political factors.
Clients often think of risk
as the prospect of an undesirable outcome, such as a financial loss or not meeting an investment objective.
Volatility
Broad market
Shortfall
Volatility
the fluctuations of investment values over time
Broad market
factors that can lead whole markets, or even most markets, to decline together
Shortfall
the risk of failing to meet a long-term investment goal
What is Risk Profiling?
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
Risk Tolerance
Risk Tolerance measures how much risk an individual is willing to take
Risk Capacity
Risk capacity is the level of financial risk the client can afford to take.
Risk capacity has to do with measurable or predictable factors such as client’s:
- asset base
- savings rates
- job and income security
- withdrawal requirements
- time horizon
Risk Required
Risk required is the risk associated with the return required to achieve the client’s goals from the financial resources available
Separating Risk Tolerance From Risk Capacity
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
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,
the appropriate level of risk is determined solely by risk tolerance.
A Four Component Model of Risk Profiling
Risk Tolerance
Risk Perception
Risk Required
Risk Capacity
Risk Tolerance
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 Capacity
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
Risk Required
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
Risk Perceptions
Risk perceptions are the unstable, short-term behavioural risk attitudes and willingness to take risk that are exhibited through an individual’s actions.
Measuring Risk Tolerance
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
How NOT to Measure Risk Tolerance
- 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
Number of methods by FSP to risk profile
Risk Profile Questionaire
Line Method
Life Cycle Approach
Sensitivity Analysis
Consequences of inadequate risk profiling
Client making investments not suitable
FSPs do not have reasonable basis for advice
FSPs unlikely to meet obligation by only using a risk profiling tool due to
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
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.
Clients often think of risk as the prospect of an undesirable outcome, such as a financial loss or not meeting an investment objective.
Describe the purpose of the risk profiling process in financial planning.
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.
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;
- 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.
- 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-timein 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.
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 - 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.
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.
Risk perceptions are the unstable, short-term behavioural risk attitudes and willingness to take risk that are exhibited through an individual’s actions.
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.
- 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.
