Risk-profiling tools have faced continuing scrutiny on whether they are fit for purpose, with new discussion emerging over the unconventional asset allocations they can lead to.
While risk-profiling tools can measure how much clients can objectively afford to lose relative to their capacity for risk, translating that accurately into investment advice is a job arguably better left to humans.
Experts say a one-step digital process that matches attitude-to-risk scores to risk-rated portfolios will never be accurate. Nor will following a pre-set plan protect advisers if the FCA asks questions about suitability.
As the compliance crunch pushes more advisers towards digital solutions, Money Marketing has looked at the growing appetite for risk tools and the next steps advisers should be taking to improve their approach to risk modelling.
Asking the basic questions
Dynamic Planner is the most widely-used profiling tool of 2018, according to Nucleus research, followed by Finametrica, Morningstar, eValue, Oxford Risk and Defaqto. Just 15 per cent of advisers solely use in-house systems.
Consultant and former FCA technical specialist Rory Percival says: “There are a number of tools in the market, especially the psychometric ones, that are very robust at assessing the client’s risk profile.
“There is a lot of science behind psychometrics and there’s a lot of data behind them to prove their value.”
He adds: “A good tool will be 90 per cent correct. As a financial adviser you don’t want to be sitting there in front of the one in 10 people where it’s wrong, because that is too high of a proportion that you’re giving misleading advice to.”
Psychometric risk profiling benefits
- Results are reliable and consistent on retest
- Questions are framed to take the emotional aspects of money into account
- Measurement is the basis for framing and managing investment expectations
- Questions are descriptive in nature and do not require calculations
The question that remains unanswered is how the risk rating for a model portfolio or certain investments can be mapped to the same scientific accuracy as the risk profile of a client.
Percival says: “There is no single valid measurement of risk as an investment, and volatility isn’t a good metric for risk in all scenarios, so the mapping stage becomes a challenge.
“Advisers need to be good at communication and interaction with their client, and probing questions that get to the bottom of how they would really respond to risks to get round this.”
Getting a genuine reaction as to how a client would feel about their investments in the event of a market crash requires good soft skills.
Percival says: “Building strong communicative skills that bring forward a true emotional response from clients would be the best practice approach for advisers.”
A Money Marketing poll this week asked whether respondents believe accurate risk profiling can be done by robots or a similar technology alternative. Half of the respondents agree that it can. A total of 35 per cent say no, while 15 per cent are unsure.
It is important to fully understand a client’s situation and to understand their objectives to a level that makes them meaningful, realistic and quantifiable as far as possible.
When you are at this stage of the relationship with clients, questions to determine their attitude to risk would cover their attitude towards financial risk, how they view their past financial decisions, and their view of risk versus return.
It’s also important to ask how others would view their attitude towards taking financial risks, how they would feel if their investments fall, and their realistic capacity for loss.
Financial & Technology Research Centre director Ian McKenna says the increasing support for automated risk tools is surprising, but overdue.
He says: “If there is recognition within the adviser community that they can start to work alongside technology, that’s going to be a huge step forward because that hasn’t always been the case.”
Advisers also need to revamp their risk-profiling process to address new requirements under Mifid II.
Despite this, more than a quarter (29 per cent) of advisers at a Dynamic Planner conference in February in the immediate aftermath of the introduction of Mifid II said they did not have a consistent definition of risk.
Oxford Risk head of behavioural finance Greg Davies says there is also little effort placed on understanding how investor risk capacity needs balancing against investors’ expectations on returns.
Mid- or high-risk investors usually expect a direct pay-off for their risk score in the form of high returns.
Davies says: “No one quite understands what that risk means, and there are no good tools out there for that. Typically the industry, regulators and tool providers have just focused on the basic risk tolerance, because that is still the easy piece of the puzzle.”
Risk profiling is integral and I can’t see how an adviser could maintain they have a robust and repeatable process without that being the starting point.
Advisers should stick to asking about how much volatility a client wants. We test drove some tools some years ago and have the Dynamic Planner tool in our process now.
If you’re a client, we go through our own questions, make a report and then mark existing funds to that, track their performance, and then determine whether the attitude to risk matches or not. It is dangerous in the extreme to pretend you can’t use a tool as your starting point.
The Oxford Risk questionnaire is used by Standard Life, Brewin Dolphin and the Bank of England, as well as the Royal Bank of Scotland, HSBC and Nutmeg.
Davies says it comprises 10 questions and provides a risk score between zero and 50.
The tool, like most, is not designed to take state of life or financial goals into account, or the capacity to deal with monetary loss.
Although Davies says working to meet suitability requirements across the industry is “rife with poor practice”, Percival says advisers cannot expect to be psychologists.
He says: “Risk profiling is a science and a single adviser wouldn’t have the extent of knowledge or data to do that. I don’t think any of the tools do the necessary quantification particularly well. That’s the area the market needs to work on better.”
McKenna adds: “Big data can do a lot comparing portfolios with outcomes, but communicating that to the customer is also where machines have a long way to go.”
Head to Head: Are digital tools more important than humans in profiling risk?
Although it may sound like science fiction technology to understand consumers’ attitudes to financial products by measuring their emotions, this has been in development for some years.
Perhaps the best-known player is nViso; its system measures micro-expressions on a person’s face to understand what they are really thinking, which may not always be the same as what they are saying.
Extensive work has also been conducted in the area of emotional recognition.
A number of other organisations are developing similar technologies and are not yet talking publicly about the work, and several industry technology players are conducting research.
Like so many areas where technology enhances the advice process, these tools complement the role of the traditional adviser and so it is unwise to discount what the science can offer.
A well-rounded judgement requires human traits and reminds us of the key role that advisers play. Advisers also need an appreciation of the behavioural biases of a client, an understanding of their attitude to money and a skill at eliciting useful answers.
It seems incredible that we are still debating how best to use a risk tolerance assessment tool. This lack of progress is due, in part, to attempts by advisers and portfolio managers to reduce their business risk via standardisation.
Regardless of the quality and flexibility of the tool being used, an accurate assessment will often require a multifaceted approach used at different stages of the process.
A mechanic would not assess engine failure risk without a regular service, nor would they complete an engine overhaul using only a Swiss army knife.