The generally accepted view from professionals and regulator’s when it comes to advice is
The term “prudent expert” has never been fully defined, but most courts and regulators believe it should be based on the principles of the “Modern Portfolio Theory from Markowitz.
This is why risk profiling is important as it helps to determine the different investment structures that is correct for each individual.
When it comes to risk profiling or risk tolerance vs “prudent expert” however it is less clear and not so defined. Despite the fact that there is a legal requirement to know your client which includes the client’s tolerance for risk. This leaves the financial industry in a situation where they have to do a best effort and hope it is correct.
I always use the example of Sheikh Zayed Road. For an average British person, it may be perceived as extremely risky, however for the Italian it is very safe compared to racing around Milan however for the RTA it is average risk.
So here lies the problem with assessing risk. We have an average rated road but the perception of both parties are completely opposite and both different than the RTA. Yet both parties have to travel on the same road. As such you should now separate this into risk tolerance and risk capacity. As time goes on peoples risk composure changes. We get older, we experience different things, our reactions get slower. This makes it difficult to use a basic questionnaire when we are dealing with abstract traits such as risk tolerance.
Due to these complexities I use a psychometrical approach to assess the clients risk capacity, a gap analysis to determine a client’s financial goal. Only then can I determine the client’s willingness to increase his risk capacity if required.
Now it is possible to manage the clients risk perception and their investment expectations on an ongoing basis. This will help prevent disappointment when the next crash or black swan event comes along.
There has been much academic study about client’s behaviour with risk and how it influences investment decisions. They have identified 3 core areas.
Risk Tolerance: – the client’s willingness to take on risk (uncertain positive or negative outcome)
Risk Capacity: – the financial ability to endure a potential financial loss and still achieve the clients’ goal. (If the goal is aggressive, then the goal itself is risky)
Risk Perception: – in my example I explained that perception is not always reality and as such the behaviour becomes inconsistent with the risk tolerance. This is often a result of a lack of financial literacy and being susceptible to news and television reports.
We see that risk capacity is an objective measure while risk tolerance and risk perception are subjective.
That is why you need to understand all three to be able to give an appropriate investment recommendation.
It is difficult to measure risk tolerance due to it being subjective, we can’t just look into someone’s mind and try and come up with an answer. That is why when questions are asked and we do an evaluation of the responses we can then work to find out about how the client feels about their willingness to take on risk. This is key to understand a client before we can recommend a suitable investment structure.
Most risk profiling forms do not do a good job at predicting a client’s behaviour during volatile markets. This can lead to unhappy clients or even legal issues.
One example could be someone whose investment has gone from 1 million to 2 million then down to 1.5 million. For me I would say they have made 500,000, however they may feel that they have lost 500,000, result “unhappy client”
Or the clients account may have gone to 1,300,000 and as such has no problem losing 200,000. The client in this instance just sees it as playing money they never had.
If the same client had invested 1 million and lost 100,000 then that could be for them catastrophic.
So we now see that even if the loss looks smaller, the way the client accepts this volatility or losses is different.
This is because when we see that the client may have filled out the risk tolerance in a calm and rational mind, when those events that cause volatility occur we now begin to see an emotional response and not a rational response. This is due to the difference between our primal instincts in our limbic system and our frontal cortex. This explains the difference between our rational expectation and the disconnect and how we react to risky events in real time. It is these reactions that causes losses and disappointment.
When it comes to planning and investments, these irrational reactions will most likely prevent the client achieving their goals. This has to be addressed in a professional manner.
This can become a science, but to summarise: when planning for investments, the correct risk analysis has to be done which has to cover risk tolerance, risk capacity and risk required. Most risk profiling systems are not sufficient to be able to do this.
We have to delve deeper into the client’s risk structures and as such one should use a psychometric profiling tool. The professional should ensure that the expectations are realistic, and these expectations are managed on a constant basis. Only this way can most clients survive volatility and achieve the desired goals (note that most investors have long term returns that are 50% lower than the market due to making emotional decisions in times of stress)
While most questionnaires are so poorly designed, they actually can end up with a worse result than not using one at all.
No matter how good the risk profiling is and setting expectations as well as managing expectations. You still need a good quality financial advisor that can spot the nuances. Each person is different and the advisor should be able to confirm the appropriates of the test results. These results should be then be used in conjunction with financial modelling tools to come up with risk adjusted returns (returns that do not take excessive risk and match the clients profile). This allows the advisor to better manage the ongoing relationship vis a vis the true clients risk profile vs the perceived risk profile and thus being able to prevent the client panicking at the last moment in a crisis.