What is Risk Profiling?

Risk profiling is the process of determining an appropriate investment strategy while taking risk into account. Sound and well thought out risk profiling practices enable advisors to understand their clients' level of risk aversion.

There are 3 primary aspects of risk, each of which has an impact on the decision making process:

Risk required – the risk associated with the return that would be required to achieve the client’s goals - a financial characteristic

Risk capacity – this means the amount of risk your client can afford to take - financial characteristic.

Risk tolerance – the level of risk the client prefers to take - a psychological characteristic

Things to keep in mind while assessing your client's risk profile:
Assess separately: Assess your client’s risk tolerance, risk capacity and risk required separately.

Compare the findings to look for discrepancies in the client’s risk tolerance, risk capacity and the risk required.

Explain risk-return tradeoffs. For example, if a client has a very high risk-tolerance but a low risk capacity, explain to him the optimum level of risk required to achieve his goals.

 

Assessing Risk Required

A good planning software should be used to determine risk required

Eliciting information: To be able to determine the risk required the advisor must be skilled in eliciting information from clients about their goals, current and anticipated income and expenses, and current and anticipated assets and liabilities.

What are the common mistakes that you should avoid while assessing your clients risk required:

Relying on historical data blindly rather than looking at expected returns in the future

Making insufficient allowances for longevity of life, health care expenses etc

Not rebalancing portfolios with regular intervals, resulting in the risk/return of the portfolio drifting away from the risk/return required

Assessing Risk Capacity

Risk Capacity is the extent to which an individual's financial plan can withstand the impact of unexpected (negative) events.

This is essential to determine given the fact that actual returns are often less than the expected returns and therefore need to be accounted for in the client's plan.

Assessing Risk Tolerance

Risk Tolerance is a psychological parameter that is largely dependent on an emotional balance.

Advisors who use industry-standard, non-psychometric questionnaires or interviewing techniques will find it difficult to establish objectively that they are making valid and reliable assessments of their client's risk tolerance. Thus, it is crucial that psychometric tests be done in order to have a clear understanding of your client's risk tolerance.

Commonly made mistakes while assessing your client’s risk tolerance include:

Vague, wrongly worded questionnaires
Lack of explanation about the methodology entailed in assessing risk tolerance

Relying entirely on subjective judgment e.g. an interview

Jointly assessing the risk tolerance of couples rather than assessing individual tolerance

Ignoring inconsistencies that arise between a client’s investment tendencies and their answers on questionnaires

Inconsistencies in the risk tolerance, risk required and risk capacity:

In about 60% of cases, there is no investment strategy that will achieve the client's goals (with the desired risk capacity) where the risk is consistent with risk tolerance - an undershoot. In simple terms, given the resources available, the client has overly ambitious goals.

In a further 30% of cases, risk required, risk capacity and risk tolerance are more or less in line.

In the remaining 10% of cases, the risk required to achieve the client's goals is less than risk tolerance - an overshoot.

Please remember that a mismatch in the risk required and risk tolerance is your client's problem and not yours- you can guide him but the final decision should be his own.

How do you deal with a situation where your client's risk required is more than his risk tolerance- Undershoot?

Take more risk

Invest more

Ease goals In a different type of undershoot, risk tolerance is consistent with risk required but there is not enough certainty that the goal(s) will be achieved (the investment strategy does not have sufficient risk capacity).

Therefore, in a simplified advice scenario, the client has three options, which allow him to address this problem:

> To commit additional funds during the term of the investment, and/or

> To extend the time horizon, i.e. delay the goal, and/or

> To reduce the goal,

Failing that, the client will need to accept the fact that underperformance of the investment would mean that the goal cannot be fully achieved in the desired timeframe.

How do you deal with an overshoot?

By way of contrast, the far less common overshoot situation presents only happy choices. The client will have options to increase, accelerate or add goals, spend more now or have a less volatile journey.

Risk Perception

Before concluding, it is appropriate to give some consideration to risk perception.

Investors, especially new investors, are usually not well-informed about investment risk, particularly the relationship between risk and return, and the range and likelihood of possible outcomes, including the possibility of extreme events.

Investors will make decisions based on their perception of the risks involved.

Risk is likely to be under-estimated in a rising market and over-estimated in a falling market.

In the former, investors may need to be cautioned and in the latter, encouraged.

It is critically important that advisors manage investors' risk and return expectations through education.

The risk profiling process presents a unique educational opportunity because the education can be directly tied to the real-life issues being considered and decisions being made.

Source: FinaMetrica, Sydney August 2013

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