Pick a colour on the risk-profiling rainbow

by Richard Allum on 7 October 2009


There is a broad spectrum of approaches to risk profiling. How far along the spectrum should advisers go in turbulent times, asks Cathi Harrison of Para-Sols?

One of the most striking and interesting aspects of financial services I have noticed is the huge variations that can still be found between firms and the way they operate.

The Financial Services Authority’s nirvana is that a consumer can go to 10 different IFAs and come out with the same advice or thereabouts.  The likelihood of this happening is slim, however, and if it were to happen I would feel it was a sad day for financial services.

Advice may differ between firms, but so does the personality of each firm, its style, approach and method. And these can also vary greatly between advisers at a single firm. That is because they are human, not robots.

The wide spectrum

One of the biggest range of differences I have noticed lies in the approach firms take towards risk profiling and asset allocation. The two ends of the spectrum are very different.

At one end is the pick-a-number camp in which the client rates their own perceived attitude to risk by allocating it a number between one and five or one and 10, for example.

At the other end of the spectrum is the method of questioning the client to within an inch of their lives, followed by a thorough analysis of their psyche and innermost dreams and fears in order to come out with… a number between one and 10. Between these two extremes lies any number of methods.

In turbulent times

During these exceptionally turbulent times, IFAs have felt clients’ wrath more than ever over their asset selections and fund choices. A few advisers will have selected funds that have performed relatively well but they will not be basking in the praise and adoration of their clients. At best, they may be met with apathy. As one adviser puts it: ‘When it goes right, the credit goes to the client. When it goes wrong, the adviser will soon hear about it.’

The effects of this seem to be to have pushed advisers ever further down their preferred profiling route. The one-to-five group, worried that even such a simple approach did not work – and tired of endless ear-bending from disgruntled clients –now find that the majority of their clients fit into one of just three categories: defensive managed, balanced managed or cautious managed.

The super analytical advisers will now go even further in their analysis, also taking into account the client’s parents’ investment history (and shoe size). But, joking aside, recent events appear to have pushed these extremes even further apart. How far should advisers go when looking at a client’s attitude to risk?

Risk profiling approaches

Should the client just pick a number? This is not as terrible an option as the critics may perceive. At the very least it enables the adviser to gauge their client’s gut reaction to risk. However, this approach is by no means comprehensive enough to constitute a full analysis of someone’s risk profile.

A few questions can be added about the client’s experience and knowledge to date, to gauge how they may understand the definition of being a ‘three out of five’. The adviser could then add a few more questions to test the client’s understanding of the risk-return rule.

For example: ‘If you invested £100,000, which of these ranges would you feel comfortable with your investment falling into at the end of 12 months: a) £95,000-£105,000; b) £90,000-£110,000…’

The adviser could also consider adding a few questions about decision making, the speed with which the client tends to make their decisions and their propensity for regret at those choices.

That has quite quickly added up to a lot of questions.

Willingness versus need

The answers to these questions only give you an indication of the maximum risk the client is willing to take. The question then needs to be answered of how much risk they need to take.

This is a concept that is rapidly being incorporated by advisers. It involves looking at the clients assets versus what they hope to achieve and determining some kind of required growth yield to meet that objective. To do this, some form of cash flow planning is often needed, which can be done using expensive, complex, time-consuming but super-accurate software or a basic, internally designed spreadsheet – or a huge range of methods in between.

This results in a well-rounded profile of the risk tolerance and risk level that it is necessary for the client to take. The pitfalls are that it can take far too long, the results of each area could contradict one another and it will probably still result in picking a number between one and five.

Ready for asset allocation

Once the risk profile is determined and you know whether the client is moderately adventurous or cautiously balanced or a number four, that can be incorporated into the asset allocation.

Each firm will have its own risk-profiling procedure with which it is comfortable, based on the level of importance it attaches to the process. It is interesting to see how firms have moved further along the scale towards detail in light of recent events. If only there was a way of knowing which method works best.

Cathi Harrison is founder/owner of Para-Sols and this article was first published in New Model Adviser.

{ 1 comment… read it below or add one }

Iain Wishart 24 November 2009 at 16:56

Good article. We ask clients to complete a detailed attitude to risk questionnaire (based on Distribution Technology questionnaire – others exist including FinMetrica) to then arrive at one of 5 risk profiles we recognise. This approach upon it’s own is much better (so say the FSA) than ‘choose a number from 1 to 10 Mr and Mrs Client’ – but is still flawed.

Through switching to Truth software (a form of cash flow modelling) we can now work out how much annual return a client requires to do all the things they want to do in life and never run out of money. Often the annual rate of return required can be very low – or even negative. New types of this cashflow software are appearing all the time – Voyant being an example of an American firm coming to the UK. It does take time and effort to learn these systems and how to apply them.

They are not as expensive when compared to losing even one case with the FOS for not correctly matching a plan/fund to the client’s risk profile.

Most advisers, when seeing a client with a say ‘6’ risk score, will set up a balanced portfolio that meets the risk score ‘6’ when, if they had carried out a real risk assessment using the cashflow approach, a no or low risk investment approach is all that was required.

Those firms having a risk questionnaire and scoring system are, from a compliance viewpoint, in a much better place than those who rely on the client ticking a box on a scale of 1 to 10, but should not be complacent as often they are selling equities, stress and risk when no or little risk is required by the client.

I remember back in 2004, the FSA asked me (when I used to use the tick box approach) these questions:

1. What do you think Mr and Mrs C understood by a risk score 4 out of 10?
2. What do you understand to be a 4 risk?
3. What questioinnaires, risk tools and sales aids did you use to establish risk? (please supply samples)

The firm I worked for lost the above case at the FOS owing to a lack of structured risk profiling being in place.

I have successfully claimed compensation for clients against the banks who, despite the tens of thousands of complaints they receive (see FOS statistics for the first 6 months of 2009 and weep), still seem to struggle to match products and funds to an investors’ risk profile or to ask the right questions in the first place.

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