Risk profiling: an alternative approach

Risk profiling remains a major part of the basis on which most financial planners make recommendations regarding an appropriate portfolio (i.e. asset allocation) for a client.

It seems, however, that in many cases risk profiling has been adopted by dealer groups in order to tick the compliance box requirements, while giving an easy to explain – although potentially fundamentally flawed –recommendation to a client.

Many critics of risk profiling are emerging in the world of academia, pointing to the anomalies that can arise in questioning techniques, such as differing outcomes when the profiling exercise is carried out in differing market conditions and the effects of framing.

Despite this, it appears that most critics – and proponents for that matter –miss a key point. Most focus on attacking the errors in questioning techniques that bring about flawed client responses. Very few provide genuinely alternative solutions to these problems and simply conclude that the questions need to be improved.

Even assuming that risk profiling (and in particular psychometric testing) was capable of accurately assessing a client’s risk tolerance, there is no guarantee that it will correspond with the selection of a portfolio that will enable a client to achieve their lifestyle goals – which should be the primary objective.

Applying the concept of risk profiling to the travel industry perhaps best portrays the issue at hand. Let’s say a nervous traveller consulted
their local travel agent and upon assessing the traveller’s risk tolerance the travel agent concluded, based on various factors (e.g. their fear of
flying, their history of only ever going on domestic holidays) that the most suitable mode of transport is a car. What, however, if the traveller
wanted to go to Europe? No matter how well the risk profiling questionnaire was framed, how well the answers were designed or how
perfectly their respective weightings, the traveller would fall short of their goal.

What happens in fact is that the travel agent would say to their client that in order to get to Europe they need to take either a boat or plane. The real advantage with this approach is that the client is fully aware of the implications if they do not accept the risks of taking a boat or a plane (i.e. they do not get to Europe).

When it comes to recommending a suitable portfolio, the logical approach is to first establish where it is the client wishes to go. This typically translates into the income figure the client needs in order to live the life they want. What this then provides is the ability for an adviser to convert these outcomes into a percentage-based required return, giving a measurable objective.

The required return then forms the basis for an appropriate portfolio selection. Importantly, it is at this stage that the risks of a particular portfolio are explained in terms a client can understand. If the client wants to achieve the outcomes they desire, they need to accept the associated risks. If the client does not want to accept the risks associated with achieving the desired lifestyle, they must lower their expected lifestyle to a level where the risks are more tolerable. Full stop!