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By Tom Street | Published May 16, 2012

It’s a risky business

One of the more positive consequences of the financial crisis has been the development of more intelligent risk-profiling techniques.

Given the focus from regulators, and financial institutions, on best-practice risk assessment and the better understanding of client appetites to risk and losses, the use of stronger risk-profiling tools and solutions is to be welcomed.

Attitudes to ‘risk’ generally have changed markedly in the wake of 2008. Where once people were happy with various investments and levels of risk, the collapse of firms such as Lehman Brothers and near-nationalisation of stalwarts such as Royal Bank of Scotland have ushered in an era of sharply shallower risk appetites for many people. Volatility in markets such as Europe and the intense focus on debt levels and ‘systemic risk’ have made sure that the fears have not receded.

As a key distribution channel for professional investment managers, financial advisers are a fundamental part of the shift towards better use of intelligent risk-profiling techniques. From a providers’ point of view, it is good to see that the use of risk-profiling tools has become a much more established part of initial – and ongoing – client communication process.

While a qualitative appraisal of a client’s risk appetite will remain a key part of this process – indeed, it is a vital and natural element of any client facing agenda – the part played by a quantitative assessment has grown in significance. Discretionary fund management providers have been helping financial advisers accommodate this shift.

It is important, clearly, to use the right risk-assessment tools and products. The FSA’s high-profile paper published last year, Assessing Suitability: Establishing The Risk a Customer is Willing and Able to Take and Making a Suitable Investment Selection, made this point very clearly.

The FSA paper also emphasised how important it is that advisers do not wholly rely on the conclusions from risk-profiling tools alone but use them as part of a wider assessment of risk and a client’s appetite for loss.

The paper said: “Where they are used within a suitability assessment process, tools and questionnaires can help to provide structure and promote consistency and so can usefully support the discussion a customer has with their adviser or investment manager. However tools may not provide the right answer in all circumstances. So where firms rely on tools, they need to ensure they consider this risk and actively mitigate any shortcomings or limitations through the suitability assessment and ‘know your customer’ process.”

The regulator added that nine out of the 11 tools it reviewed had features that meant that there was a high probability that, under certain circumstances, the output might not accurately reflect the risk that a customer was willing. It added that similar weaknesses and limitations were identifiable in ‘non-tool’ approaches.

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