OpinionMay 30 2013

Risk profiling and its complexity

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The City regulator’s defined a customer’s capacity for loss as the ability to “absorb falls in value of their investment” and if the loss of capital would have a detrimental effect on a customer’s standard of living. Which raises the question: Is capacity for loss a subjective or objective measure; does it affect the customer emotionally or tangibly? Clearly, it has to be both.

Which brings us to the core of Mr Wright’s observations, that a customer’s risk profile is possibly too complex to be systematically determined. In so far as humans are complex, with ever changing perceptions of their needs and circumstances, the best a system can do is capture some, but probably not all, points of relevance.

It is axiomatic that the adviser must advise. The adviser must engage, as one human to another, with the customer. They must allow their informed intuition to lead their examination of the customer’s needs, aspirations, resources, and constraints.

Does this mean that tools and systems to ascertain a customer’s risk profile have no role to play? Absolutely not, since without them it is very hard to bring structure, discipline and the benefits of science and evidence to the understanding of customer’s preferences.

We know that all customers’ concerns regarding investment risk are conditioned by their time horizons. Given an investment that appears on track to deliver its expected outcome at term, one customer may be unconcerned about day-to-day movements in value, while another may be extremely agitated.

There is a tendency to regard a customer’s risk category as a single indicator of the risk level they prefer, rather than a pointer towards the rage of likely risk preferences suitable for their goals and time horizons.

It is possible to consider the type of goal as a further dimension of the ‘preference space’. Customers will have some goals that they need to achieve with a high certainty of outcome.

A good adviser will explore these priorities and concerns and assimilate them; a good risk profiler can help the adviser identify, quantify and rank them.

More challenging, for the adviser and for the customer, is the question of ‘impact on standard of living’. Investor risk profiling and the understanding behind it can help a great deal.

Mr Wright notes the benefits risk questionnaires bring to the advice process, particularly in offering structure and discussion points. However, he makes some cautionary observations regarding questionnaires.