Client protection – practical ways to improve the quality of your risk profiling
Practical guidance for advisers may create a closer alignment between your advice and the client’s true attitudes towards, and tolerance for, investment risk.
Know your client, know their true risk profile
Understanding the risk profile of your clients is one of the fundamental pillars to providing advice that is in their best interests. It is also an important consumer protection mechanism, minimising the risk of consumer harm by aligning their investment and product choices with their inherent willingness and ability to take risk.
And yet, as much as the importance of risk profiling is understood by advisers, the implementation of risk profiling methodologies has previously left a lot to be desired, and inappropriate incorrect risk profiling continues to be a major source of complaint to the Australian Financial Complaints Authority (AFCA).
In this article, we will explore both the concept and context of risk profiling within financial advice. We will examine the different methodologies, the inherent weaknesses in many risk profiling questionnaires, and offer practical guidance for advisers, such that they may create a closer alignment between their advice and the client’s true attitudes towards, and tolerance for, investment risk.
ASIC on risk profiling and personal advice
ASIC’s RG 175 references risk profiling, and its centrality in the personal advice process, in a number of different ways. One is in the context of Best Interests’ Duty, with para 264 stating:
“We expect that processes for complying with the best interests duty will ensure that, within the subject matter of the advice sought by the client: (a) the scope of the advice includes all the issues that must be considered for the advice to meet the client’s objectives, financial situation and needs (including the client’s tolerance for risk).[1]
Another is in the context of products with an investment component, with para 319 stating that a client’s relevant circumstances may include:
“Tolerance for the risk of capital loss, especially where this is a significant possibility if the advice is followed”.
And yet….
Despite the assessment of a client’s risk profile being an obvious – compliant – step to undertake, historically the processes used to complete this assessment have proved problematic.
Indeed, 2015 data from FOS (from which AFCA was born) suggested 70 percent of cases escalated through them were due to inadequate or incorrect risk profiling of clients[2].
And according to analysis by risk management specialists Fourth Line[3], the problem seems to have persisted well into the AFCA era, with around 18% of all advice related complaints falling into the ‘know your client’ category, to which risk profiling problems were a major contributor (along with other failures to determine a client’s relevant circumstances).
According to AFCA data[4], roughly two thirds of their determinations relating to ‘know your client’ failures found in favour of the complainant, with one particular finding reinforcing that the biggest red flag for advisers is not the failure to complete a risk profiling or risk tolerance questionnaire (RTQ), but rather it is the inherent flaws in those questionnaires themselves, in terms of whether clients understand them and the extent to which they accurately reflect a client’s true risk profile.
Case Study – AFCA finds risk profiling questionnaire ‘too complicated’
One AFCA case related to a complainant who had been advised to switch their super to another, higher cost, fund. One of the foundations of that advice was a risk profiling questionnaire which, according to the advice firm, considered the client’s investment experience when categorising them as ‘balanced’ investors.
The complainant on the other hand argued that their lack of financial literacy meant that they found the questionnaire used was too complicated, and they were unable to understand some questions.
Upon reviewing the questionnaire, AFCA found the answers were not a reliable indicator of the complainants’ risk tolerance, particularly as they had answered having ‘limited knowledge’ of investing.
In its determination, AFCA noted:
“Given the inadequacies of the risk profile questionnaire, it is up to a prudent adviser to assist the complainants understand and comprehend the questions to identify and understand their relevant circumstances. In this instance, the adviser has not discharged his ‘know their client’ obligation”.[5]
The flaws in risk profiling questionnaires (RTQ’s) are not new news
For many readers, the flaws in risk profiling questionnaires, and the dangers in placing too much reliance on them when determining a client’s attitudes to risk, will be a familiar narrative.
As far back as 2013, ASIC, in Report 362[6], investigated advice industry practices in several areas, including the use of risk profiling questionnaires.
The report noted that nearly all of the licensees surveyed used risk profiling tools to assess their clients’ attitude to risk, with the number of questions in the tool ranging from six to 27. The average number of questions in each tool was 13.
The report went on to say that:
“Risk profiling tools should not be the only way an adviser determines the client’s attitude to risk. We are concerned that mechanically allocating a risk profile based on the outcome of a survey may not identify the most appropriate strategy for the client. For example, where the client does not fully understand the questions, or the client has a high-risk appetite but does not actually have sufficient resources to absorb the level of risk, the results of the risk profiling exercise may be misleading.”
So, what exactly are the flaws in risk profile questionnaires?
The last two decades has seen numerous studies into the flaws inherent in many risk profiling questionnaires, and by extension, in risk assessment processes which rely – partially or totally – on their results.
One study[7] published in the US Journal of Financial Planning in 2015 for example, found that RTQs to be a poor predictor of actual investor behaviour.
Also published that year was a paper[8] for the CFA Research Institute by Joachim Klement, which observed “increasing evidence indicates that the current practice of using questionnaires to determine investor risk profiles is of limited reliability”.
Perhaps the watershed research in this area though is the 2010 Santa Clara University study[9], “Beyond risk tolerance: regret, overconfidence, personality and other investor characteristics”.
In their paper, researchers Carrie Pan and Meir Statman concluded that typical risk questionnaires used to assess a client’s risk profile were deficient in 5 ways.
- Every individual investor actually has a multitude of risk tolerances for each of their mental accounts (such as retirement planning or saving for a holiday) and trying to zero in one ‘umbrella’ tolerance will fail to identify these multitudes.
- The links between answers to questions in risk questionnaires and recommended portfolio allocations are governed by opaque rules of thumb rather than by transparent theory.
- Investor’s risk tolerance varies as investment markets rise and fall. Exuberance from the rises inflates risk tolerances, while sliding markets being fear and deflated risk tolerances.
- Risk tolerance varies when assessed in foresight or hindsight. Moreover, hindsight amplifies regret. Investors with a high propensity for hindsight and regret might claim, in hindsight, that their adviser overstated their risk tolerance.
- Other propensities such as trust, and overconfidence, play an important role, yet are not addressed through traditional questionnaires. Trust makes clients easier to guide, while overconfident individuals tend to overstate their risk tolerance.
The underlying premise of the questions can also be problematic
Fundamental to understanding the likely efficacy of a RPQ is to understand the three underlying components that make up an overall risk profile – risk appetite. risk capacity, and risk tolerance.
1. Risk appetite
Risk appetite is the amount and type of risk that an investor is willing to take in order to meet their financial goals. Importantly, an individual can have different risk appetites for different scenarios, and these may change over time.
2. Risk capacity
Risk capacity is an objective measure of the amount of risk that the investor can take in order to reach their stated financial goals. Knowing the goal and timeframe and potential rates of return allows projections to be made which can help investors decide about the level of risk to take.
3. Risk tolerance
Risk tolerance is a subjective measurement of your attitude toward risk and your willingness to accept potential investment loss in search of greater investment gain. Risk tolerance is the amount of risk that an investor is comfortable taking, or the degree of uncertainty (market volatility) that an investor is mentally comfortable with. Cognitive biases can feed into risk tolerances, for example our tendency for loss aversion, where the negative emotions associated with a financial loss are greater than the positive emotions resulting from a gain of equivalent magnitude.
These concepts of risk are clearly different, tolerance and appetite are psychological concepts, while capacity is a financial concept.
A wealthy person with modest spending habits may have huge financial risk capacity, but little tolerance for volatility. Conversely, someone else may have huge psychological tolerance for risk, but lack the financial means to absorb adverse outcomes.
It can be problematic therefore if a risk profiling questionnaire mixes these concepts and attempts to come up with some sort of ‘average’ of them all, rather than trying to identify which concepts are more important for that client.
That’s not to say questionnaires – and tools – aren’t improving
Notwithstanding their widely recognised flaws, RPQ’s are still seen as effective and important, especially when compared with the alternatives. Indeed, one study found that adviser’s relying on a conversational interview alone had only a 0.4 correlation to the client’s actual measured risk tolerance[10].
For that reason, the last decade has seen much effort directed towards improving the questionnaires and tools themselves, especially their capacity to measure psychological components of risk.
These efforts have seen the proliferation of two main risk profiling methodologies – psychometric testing and revealed preferences.
Psychometric testing
Psychometric tests – sometimes referred to as a propensity measure – are designed to assess a person’s attitudes in a way that uncovers an underlying trait. They are widely used to assess intelligence, personality, and other psychological constructs. An advantage associated with psychometric measurements is that a well-designed test can account for a test taker’s deeply held feelings of regret, fear, greed, and happiness associated with financial decision-making. The widely used Finametrica software uses a psychometric approach.
Revealed preferences
Dating back to 1938, revealed preference theory asserts that the best way to measure consumer preferences is to observe their actual purchasing behaviours. Or put another way, behaviours which reveal attitudes are a more reliable indicator than stated preferences.
Rather than asking investors to state their attitudes by answering questions, revealed preference tools rely on them completing a series of intuitive decision activities through which they can demonstrate and reveal to their adviser how they make investment trade-offs at varying levels of risk and reward.
Capital Preferences is an example of revealed preference tools in the market.
Sometimes it is the process that fails, rather than the questionnaire
By now the penny has probably dropped that a risk profiling questionnaire or tool should be just one part of a more holistic process of determining a client’s attitudes towards, and ability to take, investment risks.
On a similar note, it’s not always the questionnaire that’s the issue, it’s the way we use the outputs.
The mere fact a client has a high appetite for risk doesn’t mean they should be advised to invest aggressively if that isn’t necessary to meet their financial objectives. Put another way, we shouldn’t be aiming to find out how much pain they can tolerate and then give them a portfolio that ensures they will experience that pain. Rather, we should be looking to meet their needs with as little pain as possible.
This was laid clear in clear in FOS case 433596, relating to advice about an SMSF. In this case, FOS found against the adviser, on the basis that he should have realised the SMSF’s objectives could have been achieved by taking on less risk than the applicants’ tolerance for risk indicated.
In their determination, available on the AFCA website111], FOS noted:
“The selection of an appropriate investment strategy while having regard to the applicant’s tolerance to risk requires financial advisers to:
- determine whether there is a feasible investment strategy that will achieve the applicant’s goals
- determine whether the risk inherent in that strategy (the risk required) is consistent with the applicant’s risk tolerance, and
- if there is a mismatch between the risk required and the applicant’s risk tolerance, to bring the mismatch to the applicant’s attention and conduct a transparent trade-off process”.
What is interesting and relatively unusual about this scenario is that the mismatch is one in which the tolerance for risk is greater than the need for risk, whereas in the majority of mismatches the reverse is likely true.
The challenges of advising couples
Adding to the challenges when trying to accurately assess risk profile is the differences in risk preference often encountered when advising couples.
According to research by risk profiling specialists Capital Preferences, 60% of couples have a meaningful difference in their risk preference. Yet despite this, one in five advisers working with couples were only risk profiling one member of the couple, while 53% were profiling them jointly[12].
Failing to consider the risk preferences of both members of a couple can be problematic in a number of ways, including the increased likelihood of a complaint, a higher possibility of losing the client who feels disenfranchised, and even laying the groundwork for relationship tension.
But arriving at an aggregate risk profile that suits both couples can be challenging.
Paul Resnik, then of Finametrica, suggested that where a mismatch in risk tolerance exists, it could be resolved in several ways.
“If one person takes primary responsibility for making financial decisions, and often it is the man, the couple could agree to proceed according to that person’s risk tolerance. Or they could choose the lesser risk tolerance of the two, or they could average. However, in any situation that involves the couple taking more risk than the less risk tolerant of the two would prefer, it is important to make sure both members are aware of this and have signed off on their understanding.”[13]
Another solution advocated by some advisers, the viability of which depends on the circumstances, is to construct dual portfolios, each aligned to the risk preferences of the individual.
Whichever way you go, comprehensive file notes around the path taken are a must!
Practical ways to go beyond the questionnaire
Recommendation 10 from ASIC’s Report 362[14] was:
“Advisers should ensure that risk profiling tools are just one of the methods used to understand their clients’ risk profile, and that any limitations of such tools are considered when recommending a client strategy.”
Which begs the question, what are some of the practical ways to go beyond the questionnaires to accurately assess a client’s risk profile?
As always, understanding total context and actual behaviours seems to be key. Joachim Klement, in his CFA paper15 mentioned above, suggested advisers could take one or more of the following steps:
1. Financial anamnesis
Doctors know that certain diseases have a significant genetic component, which is why they place so much importance on the family history when assessing the risks to their patient. Advisers can conduct a financial anamnesis to identify a systematic bias for or against financial risk taking by asking about the investment behaviour of relatives.
In his paper, Klement references research showing that share market participation and other parental attitudes about the riskiness of equities correlate with attitudes of their children. Asking about the financial habits of relatives can therefore shed light on the risk profile of an individual.
2. Investment diaries
Nothing conveys true underlying preferences more than the actual behaviour of an investor. What an investor chooses to invest in and how they decide to buy, or sell is more informative of risk attitudes than a questionnaire can be. Advisers should therefore investigate the past investment history of an individual. The ideal instrument to do this is an investment diary in which an investor records, in real time, transactions made and the reasons for the transactions. Over time, this diary creates a picture of the individual risk-taking traits of the investor. In the absence of a diary, a collection of past transactions gleaned from bank statements other documents can be informative. If the investor is willing to disclose past transactions and decisions, their adviser can start to develop a rich investor risk profile.
3. Investment history by market environment
Finally, advisers can shed light on the risk profile of investors by putting their investment history into the context of the markets. As discussed, the markets in an investor’s formative years can leave a lasting imprint on the investor’s risk profile. Investors who experienced the sharemarket crash in 1987, the tech bubble in the early 2,000s, or the GFC, may have a different attitude toward stocks than someone who made their first investments during the bull market of the 1990s or in late 2010s. The current environment with high rates and high inflation will be new to many investors. In short, the financial history of an investor might show areas where the investor might be overly sensitive to some risks or blind to some risks.
In conclusion
Accurately profiling the risk preferences of investor clients is a crucial consumer protection mechanism. Ensuring an alignment between financial objectives, investment strategy, and client risk tolerances is not only fulfilling the obligation to act in the client’s best interests, but also more likely to drive improved outcomes, a better client experience, and less complaints.
An extensive body of research shows the inherent flaws in some risk profiling questionnaires, and for this reason, industry best practice – and ASIC’s recommendation – is to use contemporary questionnaires and tools in conjunction with other mechanisms, in order to assess a client’s true risk preferences more accurately and totally.
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