Why it’s time for dynamic suitability

New approaches to risk profiling are garnering increased attention in recent years. Many of these, however, are over-engineered and unnecessary. This is particularly true of those that claim to simultaneously measure multiple parameters of complex decision models using ‘revealed preferences’. Such measures are unstable and, more importantly, confuse aspects of investors’ preferences that should be reflected in their ideal portfolio, with those that should be suppressed at all costs. Investors’ choices ‘reveal’ all sorts of foolish behaviour that we should help them avoid, not build into their long-term portfolio.

However, possibly the most exciting new vista in risk profiling is not about the specifics of what is being measured, but rather in when and how the data are collected. At present, suitability, client fact-finds, and profiling approaches can be off-putting to clients. The conventional presumption is that we need a comprehensive profile from the outset, exposing clients to a great deal of questioning up front, which then results in a fairly static profile thereafter. This results in poor client experience, poor subsequent commitment, and also in advisers cutting corners and box ticking in order to hasten the process.

Little is gained from this approach in terms of client education, or in emotional preparation for investing. And the solutions arrived at are often over-fitted to the client’s circumstances, opinions, and emotional state at that one specific initial point in time; and then taken to be the right on-going solution, sometimes for many years, despite constant shifts in the investor’s portfolio, circumstances, preferences, and goals.

To improve on this we need to use advances in technology, data analytics, and behavioural design (in particular techniques from gamification to help investors engage comfortably with complex systems) to blur the current distinctions between profiling, suitability, and client engagement. The initial process should be as minimal, simple, and easy for the investor as possible. The more effort it takes to start investing, the more investors (particularly first time investors) are put off. But after the first investment, profiling should be continuous.

Part of a continuous dialogue

Every engagement point is an opportunity to enrich the profile – to ask the few next questions that offer the most value in deepening customer understanding. Every change in the profile offers an opportunity to sharpen the solution, either directly through the portfolio, or by enhancing the client’s knowledge, future planned actions, or relationship. And every change to the solution is an opportunity to identify new engagement opportunities.

Risk profiling is thus ideally part of a never-ending dialogue between investor and advisor, constantly updating with more information and adapting to changes in circumstances and preferences.

The client’s risk tolerance remains the steady core around which the profile is built, and will still be most effectively arrived at through a simple psychometric questionnaire at the start of the investment relationship (refreshed occasionally). But once the basics are in place and clients have invested, assessing their risk capacity, goals, attitudes and risk behaviour can become an entirely dynamic process, both adapting and deepening through the client relationship.

Of course this is much how human advisers’ subjective understanding of their clients’ needs deepens over time. But with advanced data analytics, technology, and gamification, we are coming to the point where we can blur the distinction between formal profiling and an adviser’s human understanding, ultimately creating a profiling processes as a digital ‘decision prosthetic’, to supplement and enhance the essentially human side of investing.

Simple is best

If we want to move forward in risk profiling, we should resist the temptation to focus on ever more complex batteries of questions to elicit and parameterise complex approaches to risk tolerance. Simple is best.

We should instead focus much more on how we use this knowledge, and include simple risk tolerance measures in coherent suitability frameworks that reflect an understanding of what truly matters to clients. And we should stop treating profiling as a single point-in-time activity, divorced from the on-going client relationship and suitability. Instead, suitable solutions should be constantly adjusted to meet constantly changing needs.

First published as a blog for the Nucleus Annual Conference 2017