It is time for financial advisors to modernise their approach to Risk Profiling

Many financial advisors have not done a good job of assessing ‘risk’ nor of explaining it to clients in ways that are meaningful to them. The process and methodology is outdated and leaves their clients ill-prepared for the future they are likely to face.

Radu Vladislav, 2020

Along with identifying a client’s financial goals, time horizons and liquidity needs, financial advisors have been trained to ascertain the client’s appetite for risk at an individual level before recommending suitable solutions at a goal level. This is where the fundamental flaw in the process lies.

Traditionally, the advisor would ask a series of standard questions in order to establish a client’s theoretical risk profile. The answers to these questions would then be used to calculate an aggregate score that points to the ‘appropriate’ risk profile for that client. But the traditional approach doesn’t allow the client to properly understand what risk means, nor has it identified her risk appetite at a goal level.

There are typically five risk profiles, often given names such as: “conservative”, “cautious”, “moderate”, “moderately aggressive” and “aggressive”. Armed with this Client Risk profile, the advisor would then identify an asset allocation that has been previously created based on some version of modern portfolio theory and statistical data analytical techniques.

One of my concerns is that there are many apparent flaws in the question and answer process.

Flaw #1

Many of the questions appear to be intuitively spurious as predictors of future behaviour.

Flaw #2

It is unclear as to what extent these questionnaires have been subjected to rigorous testing and validation.

Flaw #3

It is likely that at different times (financial crisis vs boom time) clients will answer these questions differently.

Flaw #4

The scoring analysis is typically equal-weighted, although it is clear that clients would rank them in different orders of priority.

So how should Risk be assessed and, perhaps most importantly, what exactly is ‘risk’?

In this paper I would like to make the case that the professional advisor should take deliberate steps to make things simple for the client. How? By focusing on the one

element of risk that is really important and understandable to the client and by emphasising that measure of risk over all others.

Our research shows that this primary element is the risk of the client not achieving the desired outcome on the date that she desired it to be achieved.

What the client really needs to know from the advisor is whether or not she is contributing enough on a monthly basis to achieve the stated financial goal. And if not, what exactly should she do to reduce the shortfall? Or, on what later date will this goal be achieved so that she can ponder the acceptability of that unfortunate outcome?

By contrast, what currently happens is that advisors use jargon which only serves to increase the asymmetry of knowledge between advisor and client and creates an unhelpful fence between them. Why do advisors bandy about statistical terms such as standard deviation, sharpe ratio, sortino ratio, treynor ratio, value-at-risk or beta, and expect their clients to be comfortable with them? When it comes to the complex terminology of risk, it is unlikely that clients – whose main strengths are typically not financial services and statistical expertise – will get their heads around it.

We urge financial advisors to make the concept of ‘risk’ clearer to their clients. In our opinion, the role of the professional advisor is to create the journey needed for their clients to have the best possible chance of achieving the financial outcomes they desire. To achieve that outcome, some financial upskilling of the client may be required and the advisor will need to take on the role of ‘coach’, but what is clear is that success won’t be achieved by sowing confusion.

At slate, we believe that each financial goal deserves to have its own tailor-made investment solution and, in order to do that, a separate risk profile needs to be determined for each of those financial goals. That would be acting in the client’s best interests and purposefully setting out on the journey towards ‘simplified financial certainty’.

Do you agree with the above? Is that what you do? Or do you like to break this concept down into ‘risk tolerance’ (at the client level) and ‘risk capacity’ and ‘risk required’ at the goal level? Does that granularity work for you and your clients? Tell us why in the comments below.