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How do advisers sort the good risk-profiling tools from the bad?

Advisers must ask the right questions and understand the limitations of risk-profiling tools to avoid the compliance dangers associated with their use, say experts.

Risk-profiling tools have come in for heavy criticism in recent months. Most recently, Morningstar Investment Management co-head of investment consulting and portfolio management Dan Kemp claimed advisers’ use of risk-profiling tools is “dangerous” and likely to lead to unsuitable recommendations and complaints.

Speaking at the Institute of Financial Planning’s annual conference earlier this month, Kemp said most tools are based on inadequate statistics, such as using historic volatility as the key metric for measuring risk.

It comes after the FCA warned in May that it still has concerns about advisers’ use of risk-profiling tools, and after The Platforum described the tools as a “ticking time bomb” in a report in August, claiming some prioritise risk tolerance too heavily over capacity for risk.

A 2011 FCA review also found that nine out of 11 risk-profiling tools had weaknesses that could lead to “flawed outputs”.

But how do advisers sort the good tools from the bad and ensure their due diligence satisfies the regulator?

Different approaches

Experts say it is crucial to understand the differences between risk-profiling tools as they use a variety of underlying models and serve a range of purposes.

Finance & Technology Research Centre head of research Adam Higgs says: “There are generally three stages an adviser might go through in risk profiling: a risk tolerance test, a capacity for loss assessment and a risk required analysis.

“Most risk tolerance questionnaires are a psychometric test. Some tools combine that with the other stages, which may involve a stochastic projection – a mathematical hypothesis of how a portfolio will grow. Advisers may wish to use a risk tolerance test and work out capacity for loss and risk required themselves while others will use a full suite of products.”

FinaMetrica is one provider which only offers a psychometric risk-tolerance test.

Co-founder Paul Resnik says: “Advisers have an obligation to understand the weaknesses of the tools they are using and to compensate for them. Ours is a psychometric test built in the mid-1990s. There are no questions around time horizons or capacity for loss – it is purely about a person’s psychological preference for taking financial risk.”

Capita Financial Software’s Synaptic Modeller tool uses a stochastic projection from Moody’s Analytics as well as giving advisers access to an attitude to risk questionnaire.

Managing director Adam Byford says: “When people refer to the shortcomings of risk-profiling tools, they are usually talking about volatility-based processes.

“A stochastic model is a much more robust measure than volatility as it provides a ‘real-world’ forecast and takes into account a range of variables, including interest rates, inflation and asset returns.”

Moody’s Analytics managing director Colin Holmes says the firm’s use of scenario-based models eliminates the weaknesses associated with historic data highlighted by Kemp. He says: “We work with a third-party provider to generate future scenarios and assign probabilities rather than using historic data. Scenario-based models offer a more reliable tool for designing investment portfolios than ones purely based on volatility.”

Distribution Technology offers a 20-part risk tolerance questionnaire, capacity for loss assessment and cash flow analysis tool.

“We use a volatility-based model which looks at data from the past 15 years to give an expectation of future volatility,” says financial analytics director Chris Fleming.

Due diligence

Experts say advisers must ask the right questions of tool providers to analyse these differences.

Resnik says questions to consider as part of a due diligence process include: who designed the test, how has the validity and reliability of the test been established, how long has the test been used and how does it identify inconsistent answers.

Independent regulatory consultant Richard Hobbs says: “The strength of these tools depends on what assumptions are built in. Advisers must carry out thorough research.” He says the due diligence process should also be carried out at regular intervals.

Hobbs says: “As the market changes, there is a need to reassess whether the tool is appropriate for your clients. Changing tools can be a marketing opportunity and a good reason to talk to clients.”

But Higgs says changing tools creates a risk of unsuitable investments.

He says: “If an adviser uses a new tool with an existing client, there is a risk that needs to be mitigated. They need to clearly define what effect it is going to have on their clients and their investments.”

Portfolio selection

The way advisers map the outcome of a risk profiling tool to a portfolio is also a key area of concern.

Experts say some advisers are too reliant on the outcome of risk-profiling tools and are missing out a crucial final stage: justifying why the portfolio suggested by the tool is appropriate for that client.

Kemp said at the IFP conference there is a “suitability gap”, adding: “Mapping a client to a portfolio is like trying to finish a jigsaw with a piece from another jigsaw.”

Resnik explains: “There are three steps: assessing risk tolerance, mapping it to a portfolio and judging whether that portfolio matches the client’s needs. All the work is in the third stage and that may involve cashflow analysis or looking at the client’s existing assets. That is nothing to do with our process and some advisers are struggling with that
because advice is still developing from a product selling tradition.”

Fleming says: “What we do is provide advisers with a framework. We do not want them to just get a seven out of 10 risk rating for a client and stick them in a seven-rated fund – they still need to consider the appropriateness of that fund.”

Despite the potential problems associated with risk-profiling tools, experts say there are few alternatives aside from advisers using their own assessments for all or part of the process.

Philip J Milton & Company managing director Philip Milton says: “The concern with risk-profiling tools is a client’s answers will vary depending on how they feel on a particular day.

“The alternative is what professional advisers used to do, and what we still do: ask clients a range of questions and, using our own experience and analysis, make an appropriate recommendation.”

Expert view: Adam Higgs

Higgs

The questions to ask risk tool providers

Risk profiling tools are very good at helping advisers get an idea of the client’s feelings towards risk and their capacity to sustain a loss. But the end decision should be with the adviser and they need to be able to justify why they are recommending a particular portfolio. 

While this is not an exhaustive list, four key areas advisers should focus on when selecting risk profiling tools are:

  • Reliability and validity:  If the underlying risk tolerance questionnaire is a psychometric test, which most are, it should have been tested for reliability (a measure of how consistent the results are) and validity (a measure of whether it tests what it claims to test). Advisers should ask for evidence of the results of these.
  • Descriptions of risk: Ensuring that the description of risk is clear and not misleading is vital in ensuring the client understands the level of risk they are agreeing to. When selecting a risk profiling tool, firms should be comfortable with the language used throughout the tool and consider whether each risk description is presented in a way that their client base is likely to understand.
  • Unsuitable investors: While advisers can use their own skills to filter out clients that have a short term to their goal or should be focusing on debt repayment, risk-profiling tools can also help in these areas, as well as highlight completely risk averse investors. In any event, advisers should be aware of whether the tool provides assistance in filtering out unsuitable investors.
  • Inconsistent answers: The FCA has been very clear that advisers should consider their clients’ responses to risk tolerance questionnaires and flag where certain responses do not tally with the other responses. An example of this is where a client has given high risk responses to all but one of the questions. While some tools are able to highlight these automatically, others do not and advisers should be aware of this to ascertain whether this was a mistake or a result of misunderstanding the question.

Adam Higgs is head of research at the Finance & Technology Research Centre

For more information advisers can visit F&TRCs risk-profiling comparison service at www.advisersoftware.com   

Adviser views

Somal-Aj-Aurora-2014-600x385.jpg


Aj Somal

Chartered financial planner

Aurora Financial Planning

Risk-profiling tools are just a guide to be used in conversation with clients. They should not be relied on too heavily by advisers or used as part of a tick-box compliance approach.

Peter-Chadborn-MM-Peach-700.png

Peter Chadborn

Director

Plan Money

We use a risk tolerance tool as an introduction to a broader discussion about risk with the client but we assess capacity for loss and risk required ourselves as we do not want to be overly reliant on tools.

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Comments

There are 14 comments at the moment, we would love to hear your opinion too.

  1. Philip J Milton & Company managing director Philip Milton says: “The concern with risk-profiling tools is a client’s answers will vary depending on how they feel on a particular day.

    What evidence do you base this assertion on? Or is it just your ‘feeling’?

    Academic studies on psychometrically sound tests show that the opposite is true and the results remain very consistent over long periods of time and multiple tests.

    Let’s stick to the facts rather than scare-monger unnecessarily.

  2. Agree that Risk Profile Questionnaires/Tools are simply a means to gather initial client thoughts and provoke discussion around clients investment goals and terms, capacity for loss, etc… Clients do not always understand levels of loss. Some perceive themselves as ‘High Risk” yet when you ask where would they rather be in falling markets, in equities or cash they prefer the latter, thus indicating they often have no capacity for loss.

    On the electronic fact-finding front I have yet to see a FF that has a respectable RPQ. Most just have one and that certainly isn’t anywhere near good enough, especially if you have a multitude of investment goals to consider, school fees, holiday home in the sun, retirement, etc… all will normally have different terms associated with them and different ATR.

    COW’s – Customer Own Words is a must to document on your file together with your RPQ and notes from your discussions. I always ensure my clients view and agree these before I proceed to provide advice…

  3. Risk profiling has become a nightmare, not because of the FCA rules , but due to many of those who have risk profiling systems to sell.

    I would recommend anyone who has not done so read the actual guidance contained in fg11.05. I think most would agree it is pretty clear what the regulator wants, and that most of us would agree with it. As so often the problem than comes with others who then take what the regulator wants and then replace that with their opinion of right and wrong in order to flog us something based on fear.

  4. Would have been useful if the FCA had actually said which of the tools could lead to flawed output…

  5. @ Grey area

    So would somebodies risk be the same a week before Sept 11 or a week after ? or at the height of the credit crunch beginning or the end ?

    I am not suggesting it (ATR) changes on a daily basis but there are factors that do determine peoples reactions or concerns, especially news and the press ?

    I believe; yes use these for what they are, tools ! All of my clients know I am at the end of the phone, e-mail or post. I think the thing is you have to work to the clients expectation, yes they know markets and indeed the value of their investments will move up and down but constant contact is paramount, some will need more than others but in reality ATR is a movable feast !

  6. Risk profiling is only one aspect of the suitability requirements demanded by the FCA and those championing and relying on risk profilers risk missing the point. Investor suitability is multi-dimensional and covers far more that just attitude to risk. Investment needs and timescales, capacity for loss and volatility tolerance are far, far more important than ATR.

    Those solely relying on risk profilers for suitability are greatly exposed, particularly without adequate records that substantiate the investment advice provided.

    Don’t expect the FCA to tell you which ones are good or bad; they don’t tell you whether to drive a Merc or a Skoda, a car or a van. Risk profilers are mere tools but limited in the context of suitability.

  7. “How do advisers sort the good risk-profiling tools from the bad?”

    Easy peasy, simply recommend a portfolio of investments, leave it ten years, wait for a client to complain to the FOS after a market fall and claim that they didn’t want to take any risks, if the FOS says your risk profiler meant nothing, then you used the wrong one.

    Yours
    The FCA

  8. Absolutely agree, Trevor. There are good systems and bad systems but the really important thing is about how they are used. And the FCA has actually given us a really good steer on that in FG11/05.

  9. @DH
    Specifically for financial risk tolerance (which is an individual trait as opposed to an overall risk assessment which takes account od capacity and need as well) I have seen a summary of studies done on this that compared scores before and after the credit crunch. There was a movement down in region of 2-3 percentage points, i.e. not significant. However, that was over a longer period of time than a few weeks and I suspect that there may have been more significant short term fluctuations for individual clients who were directly affected.

    Being a personality trait, you would expect risk tolerance to be consistent and largely unaffected by external factors. Notwithstanding exceptional individual results the data strongly suggests that this is true.

  10. Risk profiling is only one aspect of the suitability requirements demanded by the FCA and those championing and relying on risk profilers risk missing the point. Investor suitability is multi-dimensional and covers far more that just attitude to risk. Investment needs and timescales, capacity for loss and volatility tolerance are far, far more important than ATR.

    Those solely relying on risk profilers for suitability are greatly exposed, particularly without adequate records that substantiate the investment advice provided.

    Don’t expect the FCA to tell you which ones are good or bad; they don’t tell you whether to drive a Merc or a Skoda, a car or a van. Risk profilers are mere tools but limited in the context of suitability.

  11. @ Grey Area

    Interesting, and I do not dispute your or the study findings

    However from a personal point and how I view risk (or my clients tolerance for risk), is ? well like taking your car for an MOT yes it may pass with flying colours on the day but that doesn’t mean it will a week, month, year down the line, it should be a constant source of focus, purely and simply I don’t not like the thought of having a conversation with my clients along the lines of “well you filled in the risk analysis and agreed you were a Cautious , Balanced, etc etc etc investor ! if they become concerned about the said investment or the funds/portfolio.

    On saying all this I do use a risk profile tool, but I use it as a spring board for a more in depth discussion which in turn may lead to the client and me accepting the same result or in a lot cases higher or lower outcomes.

    But at the end of the day it boils down to what you as an adviser or firm are comfortable with and how it fits into your own processes and not forgetting the clients expectations.

  12. I find that it’s more important to focus on the client’s individual objectives to determine their asset allocation. Most clients left to their own decisions will get it wrong. Consider what is their understanding of risk and what about the risk of not taking enough risk?

  13. @DH
    I think we’re violently agreeing here. Risk tolerance is one leg of a three legged risk stool with capacity for loss and risk required to achieve objectives the other two. They rarely match up which generates discussion with the client who will decide, with appropriate help, what the compromise is and which of the three drives it. We happen to start with risk tolerance but you don’t have to.

    Looking solely at risk tolerance, studies show that this is very stable and consistent. It rarely changes by more than a few percentage points even over long periods of time. That does seem counter-inuitive, especially when there are market shocks, but our own experience backs this up. It also reinforces and supports the fact that this is a personality trait.

    What can and does change is the balance between the three legs of risk such that the overall risk that is agreed and implemented in practice varies over time.

  14. Risk profiling is only one aspect of the suitability requirements demanded by the FCA and those championing and relying on risk profilers risk missing the point. Investor suitability is multi-dimensional and covers far more that just attitude to risk. Investment needs and timescales, capacity for loss and volatility tolerance are far, far more important than ATR.

    Those solely relying on risk profilers for suitability are greatly exposed, particularly without adequate records that substantiate the investment advice provided.

    Don’t expect the FCA to tell you which ones are good or bad; they don’t tell you whether to drive a Merc or a Skoda, a car or a van. Risk profilers are mere tools but limited in the context of suitability.

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