Where much current risk profiling is flawed

Where much current risk profiling is flawed

Risk profiling is essential to providing good advice, and to ensuring regulatory compliance. Unfortunately, the profiling field is rife with misunderstanding and poorly designed assessment tools, leading many advisers to view risk profiling as an unnecessary box-ticking exercise, rather than a simple and effective way to improve client outcomes.

A particularly problematic approach to profiling is the failure to distinguish between risk tolerance and behavioural attitudes to risk. Risk tolerance is an investor’s stable, reasoned willingness to take risk in the long term, which reflects the level of risk we should deliver for a client over the entire investment journey. Behavioural risk attitudesrepresent the unstable, short-term willingness to take risk that is exhibited through an investor’s actions. These behaviours are, by necessity, transient and context-dependent—not the kind of attitudes we want in the driver’s seat for our long-term portfolio optimisation.

By conflating risk tolerance with behavioural risk attitudes, advisers will potentially replicate (or optimise for) all the silly things investors do already, rather than helping to mitigate and control investors’ more-destructive tendencies. This is exacerbated by the ill-advised trend of using observed behaviour (or “revealed preferences”) to determine risk tolerance. Such over-engineered and unstable approaches for measuring risk tolerance are inappropriate because a client’s actual behaviour is never purely reflective of risk tolerance—instead of providing a clean measure of risk tolerance, revealed preference approaches result in a biased muddle of risk tolerance, and context dependent behavioural responses.

Another common failure of risk profilers is to try to elicit separate measures of tolerance for different subcomponents of a client’s overall wealth. Although it may be perfectly appropriate to divide a client’s wealth across investments with different levels of risk, the characteristics of a product or portfolio must not be confused with the investor’s risk tolerance. This misconception sometimes manifests through the use of “required” returns as inputs to the investment solution, whereby investors can be encouraged to take more risk to meet an ambitious final growth target. This is dangerous: if investors’ wealth cannot deliver their aspirations without breaching the levels of risk they are willing and able to take, then the right answer is not to gamble, but to save more, or to reduce future expectations.

Lastly, an often overlooked—but vital—component to risk profiling is risk capacity. Risk capacity chiefly concerns investors’ ability to meet future liabilities, so there is an essential connection between risk capacity and both a holistic view of the client’s current circumstances, and goal-based investing. The risk investors are willing to take might not be the same as the risk they are able to take! Risk capacity is the vital pivot, turning information from the wealth-planning process into a measure of the appropriate risk level for the investment process.

The greater complexity of risk capacity means it is easy for those with vested interests in selling particular approaches to obfuscate the debate. For most investors, risk capacity is overwhelmingly more important than risk tolerance; and yet industry debate centres on an unnecessary search for ever more sophisticated, and in many cases misguided, ways of eliciting risk tolerance. The real gap lies not in how risk tolerance is measured but in how it is used. A simple, well-designed measure, used well, is hard to beat.

If we genuinely want to determine the right amount of risk, it is not sufficient just to measure risk tolerance. It is also not sufficient to supplement this with a narrow model of risk capacity. We also need to help people understand, articulate and dynamically adapt their future goals, plans and aspirations over their journey. Effective goals-based investing is necessary to truly find the appropriate risk level.

But the best investment solution is not just about establishing the theoretically “right” solution—at least as important are other behavioural risk attitudes that affect anxiety during the investment journey. Profiling should provide an opportunity for investors to learn about their attitudes, emotions and biases, and in doing so, it should help them prepare for the anxiety that is sure to arise from time to time.

Emotional comfort is never the goal of investing, so portfolio construction should seek to help investors mitigate and manage these behavioural attitudes, rather than pander to clients by optimising for their inevitable urges to respond emotionally. Often that means moving slightly away from the “best” solution, if by doing so we purchase a big reduction in anxiety efficiently and cheaply—that is, with as little deviation as possible from the solution that best fits their long-term risk profile. The optimal solution needs to be both efficient and comfortable. What investors really want is not the highest risk-adjusted returns: they simply want the best returns they can get relative to the stress, discomfort, and uncertainty they’re going to have to endure over the investment journey. In other words, they want maximum anxiety-adjusted returns.

A thoughtfully designed profiling and suitability process can cut through all this complexity, focusing on solutions clients’ needs that account for all three of these essential components: risk tolerance, behavioural risk attitudes, and risk capacity.

To progress further we should focus on developing dynamic models of risk capacity, and tools that truly help investors understand and articulate their own goals. We should concentrate much more on how we use the knowledge we obtain from profiling. And we should stop treating profiling as a point-in-time activity, but instead ensure that the suitability process adjusts dynamically to meet the constantly changing needs of investors.

The ultimate new vista in risk profiling is for it to become impossible to separate from goal-based suitability, and from effective client engagement.

For the full article on which this blog is taken, see New Vistas in Risk Profiling.