Risk tools – are they all that?
16 January 2019
This article was originally published in Multi-Asset Review.
So, back to basics. There are two sides to the equation. Firstly, and most importantly, the client. There are essentially two types of client. There are those that understand and are prepared to take some risk in return for potential reward and there are those that are not prepared to take any risk with their hard earned savings.
I don’t think you need any type of tool to identify the latter category, although discussions around goals and future anticipated lifestyle may lead a client to conclude that taking a little risk could be necessary.
There are any number of tools out there that will help identify the natural risk profile of a client. Once real world capacity for loss and anticipated timescales are taken in to account the client will probably have a risk number attributed to them that falls on a scale between minimal risk and ‘gambler’. This equates to a level of investment risk they would not be comfortable exceeding.
Using the relevant tools
I am not going to critique the tools used to establish a client’s risk profile as the regulators have issued plenty of guidance on this and continue to do so. However, I would suggest that there does need to be some science or logic behind them and the advisers who use them do need to understand them and more importantly, be confident in their use.
As the outcomes of these tools are often the starting point for identifying suitable investments, which more often than not have been risk rated, it is important that the fundamental methodology of the client risk profiler is compatible with the methodology for risk rating the investment solutions.
A little note of warning for the client side of the equation. The questions asked in establishing the clients risk profile are likely to be geared towards wealth accumulation. You should be asking a different set of questions for clients whose priority is income. As an example, a client who can accept a certain amount of volatility in their capital value as they are accumulating wealth, may only be willing or able to accept minimum volatility in their income.
Right, let us hop to the other side of the equation. The question that many of us are trying to answer, and provide a solution to, is: ‘If the client has a ‘risk number’ created by a risk profiling tool, what is the best way of using this information to establish a suitable investment for the client?’
The safest way is to use an end to end solution that uses the same science and methodology for rating the client as is used for rating the investment solution. If this is not the case, the tools used on either side of the equation do need to be compatible. This may mean mapping risk tools to each other where possible, bearing in mind different scales of ratings, different time periods, different measures of volatility and historic volatility vs predicted future volatility.
All a bit tricky, but if you remember a few simple rules and focus on what you are trying to achieve for the client you shouldn’t go too far wrong.
- Pay attention to what the regulators are saying about suitability and attitude to risk. Historically they have given great guidance and in this respect have genuinely been trying to keep everyone on a sensible path.
- Understand and be comfortable with the science and methodology behind the client risk profiling tool being used. If you don’t, you will not be in a position to judge the methodology and science behind investment proposition risk rating methodologies which you may want to map to.
- Make sure client risk and investment proposition risk are compatible if you are matching one with the other.
- Although risk ratings for portfolios that are risk focused should not change, short term asset allocations can, either through active decisions from the portfolio manager or through changing market conditions. This means that investments can fall out of their risk rating boundaries over the short term. This is ok and to be expected from time to time, but portfolios do need to be monitored on a regular basis to ensure that the longer term risk trend is stable over the longer term and not reflective of a more permanent change.
- Even risk targeted funds fall out of their intended risk bands from time to time, so even these portfolios need regular review.
- Remember, risk is only half of the solution. Potential returns are equally as important. Make sure clients are being rewarded for the risk they are taking. This requires professional judgement at the start and regular monitoring of progress.
A useful guide
Risk profiling tools and risk ratings are in the main a great help to advisers and certainly, even taking in to account their occasional faults, more helpful than entering in to a selection process based on portfolio name or a third party’s view of what sector they sit in.
I also think it is worth adding that I am not totally wed to the idea of using tools to select appropriate investments for the client. There will be a lucky group of advisers who know their clients so well that discussion, good due diligence and an intimate knowledge of their aspirations and goals will be more than sufficient to make a recommendation. But remember, even then, as far as the regulators are concerned all conversations and justifications for recommendation need to be articulated and recorded for the client. No evidence means no justification.
Ultimately, for most, using a bit of science and technology to help in investment selection has got to be better than picking from a list of sector funds, basing selection largely on past performance. Just make sure you compare apples with apples, possibly different varieties of apples, but be as consistent as possible and remain focussed on what you are trying to do for the client.
If you don’t have currently a license, you can learn more about Engage Core, our end-to-end financial planning tool, and request a demonstration, here.
You might be interested in other Insight articles.