The importance of risk profiling

This article is part of
Winter Investment Monitor - December 2014

The importance in the advice process of risk profiling and asset allocation has grown considerably in recent years.

A lot of time and expertise have been applied in establishing a client’s true risk profile and corresponding suggested asset allocation.

Consequently, there has been less focus on specific consumers’ needs or their long-term expectations. With a completely new pension world soon to be upon us, it is vital consumers are given reasonable expectations of what financial products may provide for them in the future.

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Advisers, therefore, need to ensure that their clients’ financial forecasts are as realistic as possible. This will not only help their clients understand the potential range of outcomes from different financial strategies, but will also allow them to make informed decisions.

If consumer expectations are not managed properly, it could lead to unwelcome surprises in the future if investments deliver less than anticipated. Successful and compliant advice processes are, therefore, becoming increasingly dependent upon the integrity and quality of the underlying asset model used for financial planning.

Asset models are built for a variety of uses and it is the responsibility of the builder of the asset model to ensure it is fit for its intended purpose.

In order to be robust and produce a realistic range of potential retail investment outcomes for the consumer, an asset model used for financial planning purposes needs to be built around the following four principles:

Real-world model

The asset model should be a comprehensive real-world asset model, such as an economic scenario generator (ESG), which seeks to model investment markets as accurately as possible. It should include appropriate and consistent risk premia between different asset classes.

It must also reflect real investment attributes, such as the term dependency of risk and return associated with different asset classes. For example, the expected variation of potential cash returns in the long term compared with their current levels. An ESG links economic variables, currencies and asset returns so that consistent, shorter, long-term forecasts of global investment markets and economic variables can be produced.

Interest rates and future income

Modelling interest rates is of fundamental importance when modelling return and risk over the long term. When interest rates increase, the market price of bonds will fall, but future expectations from that point onwards for cash and bond income will be higher.

In the long term, most clients will need to generate an income from their investments, which is linked for all asset classes to interest rates in various complicated but explainable ways.

To provide integrity, an asset model should have an internally consistent model of the potential evolution of bond yield curves and consequent interest rates. This is an area of ongoing research in the modelling community as models are updated to address the challenges of the current low interest rate environment.