The risks of risk profiling

How effective are current risk profiling techniques? Do they achieve their aim (to determine a suitable investment strategy) or are they being undertaken simply to tick the boxes in terms of compliance? Patrick Barker, Private Client Portfolio Manager at Cannon Asset Managers, explores these issues and looks at alternatives.

Man on tightropeThere has always been a strong debate around the effectiveness of risk profiling, with protagonists claiming that it is a necessary step in the process of measuring risk tolerance and helps with asset allocation decisions, and the opposers stating that it should not be considered at all as the investor’s risk tolerance should be defined by the outcome they expect given their goal. In other words, they should be informed of what risk tolerance – and therefore asset allocation – they have to accept given their needs.

Methods of assessing the risk profile of an investor have developed in stages over the past 30 years. From the early questionnaires of the mid-1980s, which included rudimentary scoring, to psychometric risk tolerance testing in the mid-to-late 1990s, scientific methods were progressively introduced into the process.

Risk profiling essentially tries to determine investor behaviour and attitude towards risk. It is natural for people to want as high a return as possible, but not all are prepared to tolerate the higher risk that is required to generate that higher return.

The questionnaire approach

Risk profile questionnaires are based on a premise that when answering, people know themselves well enough to accurately portray their personality and associated behaviour. However, our personality is not always an indication of our true nature, as we can change as the environment changes.

For example, most people will be aggressive in a bull market, particularly nearer the top of the market, and they will be more conservative in a bear market. Therefore, for the average person, their risk profile is a moving target which will possibly be different in extreme market conditions and more consistent in stable market conditions. In fact, the most accurate form of profiling would be experience: how does that investor actually behave given a particular set of circumstances?

Can we truly say that using a risk profile questionnaire as the basis for asset allocation is the right way to structure a portfolio? The common risk profiler incorporates a number of questions, some of which test the client’s possible behaviour given an event, which have a score associated with them. At the end of the questionnaire, the score is totalled and this indicates the client’s relevant risk profile.

The analysis approach

Perhaps determining an investor’s risk profile through a process of analysis is more effective.

Using this approach, the analysis starts with the goal in mind. This would usually be the investor’s required income goal in current terms, but projected to a certain age, for example from age 55 to age 90, using current inflation and return rates. Already-accumulated assets are then factored in and a required return to achieve the goal is calculated, taking inflation into account. This then determines the risk needed to be taken – be it aggressive, moderately aggressive and so on – in order to achieve the desired return.

Obviously this risk is tempered by what additional monthly contributions can be made, or by reducing the goal, or by delaying the start date of the goal. The client is then told what risk profile, and therefore asset allocation, is needed to achieve these goals. In other words the exercise is done in reverse, and this certainly has some merit.

However, when one assesses risk this way, the behaviour of the client is not taken into account which could result in an irrational outcome in a live scenario. As an example, if the client’s required return to achieve their goals is 20% per annum, but their risk profile questionnaire indicates that they are conservative, it is clear that these two do not align. This client would experience high levels of anxiety when faced with the volatility of such an investment strategy and could make irrational decisions.

By doing both the planning and then merging it with the risk profile questionnaire of the client, perhaps a better overall picture is painted. This will mean that the client might need to temper their goals or ride the wave of volatility. In addition to this, detailed communication with the client, explaining what each means with an overlay of their objectives, is vital.

So how could we make these combined approaches more effective?

Risk profile questionnaires need to be far more effective in determining risk tolerance. The three-question profiler is really only designed to appease regulation requirements but does not serve the client in any way. And the questions asked in some risk profilers could be far more probing. The development of questionnaires using in-depth psychology as the backbone would be far more effective.

Perhaps asking a client additional and simple questions such as “Do you have a budget?” would help us to establish how close they are to their reported risk profile. Generally, a more conservative person will budget because they feel a need to watch their spending, for whatever reason, whereas the more aggressive person will not. Another useful question is “If your investment dropped by 20% would you disinvest, stay invested as is, or add to your investment?” This would help confirm the risk mind-set of a client. One who chooses to disinvest would lean towards being conservative and the client choosing to add more would lean towards being aggressive.

When we are identifying what profile an investor needs to adopt, because of their current financial situation, it is important to establish their goal in terms of return, and how they have come to the point of establishing that. What calculation have they done? Has it been based on their income needs? Have they consulted with a professional on this? And then in the questionnaire perhaps add the extra questions such as “What is your expected return relative to CPI for this investment?” and “Do you understand the risk and reward conundrum?”

Ultimately, the best form of profiling is experience. But we do not always have the luxury of this, given society’s obsession with instant gratification. It therefore makes sense to use as many tools as possible to give the client the best options with the glue being communication and discussion.

Cannon Asset Managers is a niche investment management company that applies the philosophy and principles of value investing.

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