From Adviser Guide:
Updated Risk profiling
Q: What are the pros and cons of risk profiling tools?
Profiling tools are often embedded within a wider software package or available on a standalone basis.
Some stop at the risk profiling stage while others have a line of sight from analysis through to a final product recommendation.
The degree of integration into back office systems will be a consideration for some advisers, keeping client data in a single repository.
Product provider tools are available on adviser extranets, typically supporting fund selection from within a set range.
Whatever and wherever the tool is located, the adviser has a duty to understand the functionality and assumptions used within the software solution. Some tools and providers are more transparent than others.
Speaking in 2011, Paul Resnik, co-founder of FinaMetrica, said most UK advisers use some form of risk questionnaire, which may be one provided in their planning software, by a product supplier or as a required element from a compliance department.
Typically, he said the client completed it quickly, often with the adviser’s assistance.
Then, he said one of two things occurred - either the adviser moves on to the real portfolio design process or the risk questionnaire itself is used to select an investment portfolio directly.
Mr Resnik said this last type of profiling was known as a portfolio picker strategy.
Questions are asked about goals, experience, risk capacity, risk tolerance, etc, to select one of five or six investor styles, for example “A Prudent investor who values security of capital …”.
Each investor style has its own model portfolio/asset allocation.
According to Mr Resnik this reduces the whole planning process to an intellectually empty and ethically indefensible quiz.
Normally, he said the designer of a portfolio picker starts with the model portfolios/asset allocations and works backwards to a questionnaire and scoring algorithm – a very arbitrary process.
Mr Resnik said: “A recent empirical study of 131 such questionnaires showed alarming results.
“When all questions in the questionnaires were answered in the most conservative way, the percentage of assets recommended for stocks ranged from 0 to 70.
“When answered in the most risky way, the percentage of assets recommended for stocks ranged from 50 to 100.”
Mr Resnik said one consequence of the industry’s reliance on portfolio pickers is that many advisers have a poor understanding of their clients’ risk tolerance.
Statistical studies typically show correlations of .4 or less between advisers’ estimates and measured risk tolerances.
According to Mr Resnik correlations of this order give errors of two or more standard deviations for one in six cases.
This means that advisers would be more accurate if they made no attempt to assess clients’ risk tolerance and simply assumed all clients were average, Mr Resnik said.
Putting these inaccuracies another way, Mr Resnik said when risk tolerance scores are converted to an indicative growth and defensive asset split the difference could be 30 per cent or more.
The FSA stated it reviewed 11 risk-profiling tools and found nine had weaknesses.
It is the responsibility of the adviser to look at each tool, understand who it is designed for and how it works and ensure it is fit for purpose as a component of their sales process and business model, Anna Cook, senior proposition manager of Aviva, warned.
She said: “Many tools focus on risk taking preferences of the customer, rather than the customer’s wider financial circumstances which emphasises the need to have broader steps in the sales process.
“For example, Aviva’s tool is not designed for use with customers who are not prepared to take any risk so an adviser using our tool must be able to identify these customers themselves.
“However, unlike many of the tools, Aviva’s RPQ includes a number of validation questions which, when answered in certain ways, will flag that some of a client’s answers contradict each other.
“It also provides probability figuresto give advisers a guide to how close their client is to a higher or lower risk profile. Combined with an adviser’s existing knowledge of their client, these support tools will help to create a clear and accurate assessment of their client’s attitude to risk.”