Observations regarding discussions of Risk Profiling within the Australian Financial Advice Sector
5th June 2017
A recent article about investor risk profiling in the Financial Observer claims, ‘assuming that changing attitudes and investor behaviours were commensurate with a change in their appetite for risk was often “flawed thinking” as the behaviour of investors in situations where a high level of risk was prevalent was not always a function of risk tolerance alone’.
Contrary to what the article implies, Oxford Risk firmly agrees with this statement: the separation of the investor’s willingness to take risk – a psychological trait of measured by a risk tolerance assessment – from their personal circumstances and past behaviours must always be ensured. As such, psychometric assessments, should exclusively focus on establishing tolerance for risk. That measure will then place investors relative to one another – in terms of tolerance – and acts as a starting point for the risk profiling process. Conflating this measure with the behaviour and financial circumstances of the investor is indeed "flawed thinking”, and would be actively discouraged by regulators in most English-speaking markets, including the FCA, the OSC and the ESMA.
The article goes on to provide a quote to exemplify the problems created by failing to separate risk tolerance from the investor’s circumstances and behaviour:
“Here's a simplistic example. Someone with a long time horizon and a low risk tolerance will be given the same outcome as someone with a short time horizon and a high risk tolerance and we know that these two clients require different strategies.”
Oxford Risk views this approach to be very simplistic, and the outcome would be totally unsuitable. Aligning a risk tolerance category with a suitable investment strategy requires more input into the risk profiling process. The behavioural traits and circumstances of the investor will play a part in deciding which strategy they should follow, and this information must be considered alongside the investor’s risk tolerance. Furthermore, the most suitable solution for a given investor depends not only on their circumstances and risk tolerance, but also on the array of choices offered by the advisory service. Understanding investor preferences in the context of a limited range of choices is a critical component of ensuring the correct mapping of an investor’s risk profile to the portfolio’s level of risk.
Risk tolerance is a measurement of the client's willingness to take risk, which is a relatively static measure over the course of an investor’s life. On the other hand, investors’ risk preferences do change. This difference between these two traits was clearly demonstrated during and after the 2008 global financial crisis. In 2010, despite the lows of the previous 18 months having passed, records show that investors’ preference for risk had greatly reduced. Since then, the same investors have shown that their preference for how much risk to take has slowly increased, even though their general willingness to take risk – that is, their risk tolerance – always remained them same. Preferences for risk can be affected by a myriad of external factors, such as market performance, past investment experience and personal financial situations. Unfortunately, this concept of an overall risk preference, which goes beyond risk tolerance and risk capacity, is often ignored by the risk profiling industry.
“Risk profiling approaches have advanced significantly in the past 20 years, and we now have clarity over investor preferences that comes directly from testing real solutions with different investor groups. Understanding how preferences align with other risk profiling factors – such as risk tolerance – has been the key of Oxford Risk’s suitability analysis. We will continue to base our work and offers on empirically derived instruments, which have at their core the establishment of risk tolerance (via psychometric instrument), the understanding of investor preferences (via on-going research with actual investors), and the ability to engage and consider the effects of circumstance (risk capacity and/or goals).”
André Neves Correia, Director, Oxford Risk
Oxford Risk is one of the world's most trusted authorities in investor risk profiling. Clientsinclude HSBC, RBS, Rathbones, Nutmeg and Brewin Dolphin.
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