Typical risk profiling mistakes and how to avoid them

Finametrica founder Paul Resnik argues that risk profiling tools are all very well, but it is a financial adviser's ability to use those tools that really matters.

Investment suitability is the foundation upon which good investment advice is built.

Not only must the investment be suitable with regards to the investor's goals, but also with regard to the investor’s risk capacity and risk tolerance.

It requires sound processes and robust tools (which are now readily available) and advisory skills.

Getting investment suitability right is therefore a blend of art and science. 

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The science lies in the tools the adviser uses.

The art lies in the adviser's ability to use the tools effectively, to work collaboratively with clients to obtain an in-depth understanding of their needs, to assist clients in resolving mismatches by identifying and explaining alternatives, and to guide the decision-making process.

Standards are raised through a combination of pull and push.

The pull comes from the example set by those leading advisers who continually seek best practices.

The push comes from regulators.

This is slower in Australia than the UK, where the regulator is setting the pace for the rest of the world.

Common risk profiling mistakes

Unfortunately, risk profiling mistakes are widespread.

These mistakes won't necessarily result in bad advice, but when they do, they are likely to lead to unhappiness for both adviser and client.

With regard to assessing risk required, the following mistakes are common:

• projections use historical data blindly rather than forward-looking expected returns;
• unrealistically optimistic assumptions are made about expected rates of return;
• insufficient allowance is made for possible increases in expenses, particularly health and long-term care expenses;
• insufficient allowance is made for longevity, particularly the likelihood of their clients living (significantly) longer than life expectancy;
• portfolios are not rebalanced, so that over time the risk/return of the portfolio drifts away from the risk/return required; and
• the adviser has too few choices with regard to asset allocations or they are too widely spaced.

This last point may require some clarification. Advisers who custom-build asset allocations can, in effect, position a portfolio at any point on the efficient frontier.

However, most advisers work with a limited set of model portfolios – usually five or six – because this simplifies administration and so reduces costs.

Having too large a gap between the available asset allocations can be a problem.

With regard to assessing risk tolerance, the following mistakes are common:

• making no serious attempt to address the client's risk tolerance. Advisers either:
  • use simplistic questionnaires to mollify compliance departments allowing them to get on with the 'real' business of advice; or
  • explain the risk in their recommendation and, assuming that the client has understood this explanation, proceed – unless the client objects;
• relying on interviewing skills to make an assessment; 
• asking couples to complete a risk questionnaire jointly, rather than each doing their own; and
• relying solely on the results of a risk tolerance questionnaire and not dealing with inconsistencies in a client’s answers.

With regard to identifying and resolving mismatches, the common mistakes are:

• not identifying them in the first place, particularly with regard to risk capacity;
• not having a robust methodology for translating a risk tolerance score into a tolerable asset allocation;
• downplaying the importance of risk tolerance, particularly where the adviser is highly risk tolerant [most advisers are considerably more risk tolerant than their clients];
• overplaying the importance of time horizon in the mistaken belief that there is more certainty about investment results in the longer term;
• presenting a solution (based on the adviser’s values and risk tolerance) rather than finding a solution through a collaborative process which gives due regard to the client's values and risk tolerance.

In larger organisations, and even in some smaller ones, these mistakes are compounded by inconsistent behaviour across advisers. 

The organisation uses different risk tolerance tests in different departments; advisers do not use the results of the test consistently in their advice to clients, advisers use different descriptions of risk in their communication with clients and this is often different from the way risk is described in the investment products recommended. 

Clearly, advisers cannot be expected to behave as clones of one another, but in a given client situation their advice should be broadly consistent.

Of course, making mistakes about the client’s risk tolerance and/or risk capacity will not necessarily result in dangerous advice.

However, some clients will be overexposed to risk, which can have disastrous consequences in a market downturn. 

Then, increasing anxiety can cause a panicked sale at or near the bottom, destroying financial and emotional wellbeing.

While there are many more advisers who now follow risk profiling best practices, the majority still operate without full understanding of the ‘state of the art’.

However, standards are moving toward greater sophistication, which is to the benefit of both investors and their advisers, and this can only help in restoring the public's trust in the financial services industry.