Getting risk profiling right is a key issue for financial firms. Following research in 2010, the regulator concluded that 50 per cent of clients suffered misaligned risk profiles and strongly advised firms to understand the limitations of risk-profiling/asset allocation tools. Of 11 tools reviewed, the regulator found that nine had serious weaknesses and led to flawed outputs.
So why is risk profiling a problem?
There are two types of risk that affect a client’s investments: systemic and non-systemic. Systemic risks are the macro-economic, uncontrollable factors that move the markets. Gross domestic product (GDP) tends to affect equities. As we have experienced in China, falling GDP forecasts has resulted in falling markets. Conversely, changes in interest rates tend to impact on fixed interest assets.
Systemic risk is measured using Beta, how volatile the client’s portfolio is compared to the benchmark or market selected. Investment theory uses the capital assets pricing model and Sharpe ratio to explain the impacts of systemic risk.
Non-systemic risk can come from the firm’s accounting metrics, assuming the systemic risk is stable, volatility of the asset, based on its historic returns.
Non-systemic risk is measured using modern portfolio theory and standard deviation. An adviser might select two assets, each with a 5 per cent return. Further analysis may suggest Asset 2 has experienced more volatility than Asset 1 to achieve the same profit, so Asset 1 ought to be selected.
A reasonable conversation regarding risk with a client ought to start with the timeframe for investing along with their objectives. As alluded to above, the client’s risk profile could be assessed on their evaluations of both systemic and non-systemic risk. Systemic risk,is perhaps more aligned to the client’s emotions; they tend to talk about markets, countries and continents as opposed to assessing individual companies or asset classes.
Arguably, advisers fail to explain risk correctly and rely on third party tools to do a poor job for them. The FCA makes it clear that focusing on the volatility of non-systemic risk – usually based on past performance – is completely flawed. Inflationary, liquidity and the crucial macro-economic risks must be included in the risk assessment. The FCA was deeply concerned about the reliance of volatility (Beta) as the single measure of risk suitability.
To reduce systemic risk, investment theory suggests we ought to diversify asset classes or products. A high concentration of a single product (for example, structured products) was highlighted by the FCA as providing additional risk. To reduce non-systemic risk, advisers ought to ensure the returns of the assets selected cannot be achieved with a lower standard deviation.
It should be noted that investment theory has one major flaw, it does not consider behavioural theory. Regardless of the effort exerted to ensure an accurate risk-profile, clients will exhibit inconsistent thinking-styles in times of high volatility. Herd behaviour, selling and buying with the market, along with anchoring on a single metric and overreacting will all result in irrational behaviour.
Behavioural issues perhaps could be avoided by educating clients on systemic and non-systemic risks. It must be confusing for a client to experience rising markets and falling valuations on the basis the adviser has failed to diversify the asset classes or explain non-systemic risk correctly.
I believe risk-profiling tools in most cases are poor and hold immense limitations; at best they are blunt and should be avoided in favour of an educational based conversation on volatility, diversification and, more importantly, the nature and forms risks take in both markets and companies.
If advisers wish to avoid complaints and poor client outcomes, they ought to focus on educating clients fully, spending time explaining systemic and non-systemic risk and the consequences of both.
Richard Bishop is a lecturer in financial services at Coventry University College and a practising regulated financial adviser
