Going beyond the risk tolerance questionnaire
There’s no doubting the necessity for accurately assessing a client’s attitude to risk and capacity for loss. There’s no shortage of tools for gauging a client’s willingness to take risk (though perhaps fewer that can quantify their ability to absorb losses).These range from verbose questionnaires with granular outcomes to simple tick box exercises with much more straightforward answers.
In 2011, the then Financial Services Authority released a guidance paper on assessing the suitability of an investment product in terms of a client’s attitude to risk. The paper outlined key risks, which included ‘poor questions to establish the risk a customer is willing to take’ and ‘inappropriately interpreting customer responses to questions.’ The paper went on to condemn the use of ‘vague, unclear or misleading descriptions,’ which cautions against taking terms such as ‘balanced’ and ‘cautious’ at face value when referring to risk appetite.
As you would hope, the adviser community is duly aware of their clients’ risk appetites. Reassuring data from the Financial Ombudsman Service’s annual complaints review shows that just 0.5% of all complaints received were in relation to Independent Financial Advisers (the lion’s share – 79% – were in relation to banks).
Although promising, it doesn’t hurt to share best practices given that the FSA Guidance Paper on the subject is rather out of date. There is little argument that risk tolerance questionnaires are, on the whole, a useful exercise as a jumping-off point to get a true understanding of a client’s willingness and ability to take risks with their savings and investments. By using a popular tool such as Distribution Technology’s Dynamic Planner or Finametrica, you can outsource the due diligence on consistent outcomes for the range of investment products matched to their tools. This forms a solid basis for then taking the analysis of suitability a step further.
By way of an example, Russell Investments provides estimated risk and return figures for each of our model portfolios to give a much more quantitative concept of what a particular risk profile is likely to feel like.
The above chart shows that our Balanced portfolio has an expected return of 4.6% with an expected volatility of 8.1%. What this essentially means for an investor is that over a one-year period, they can expect returns of between -4.5% and 12.7% (calculated by taking the return expectation and then adding and subtracting the volatility expectation). This helps make the discussion around risk, return and capacity for loss less amorphous and allows you to ask your clients ‘how would that feel?’ If potentially losing 4.5% of the investment isn’t comfortable, check with a less aggressive solution such as our Moderate portfolio:
By taking a step down on the risk spectrum, the expected range of outcomes for an investor over a year is now -2.4% and 11%; a 2.1% reduction on the downside risk for just a 1.7% reduction on the upside potential. Now you can ask if your client feels more comfortable with that and help them make a more concrete decision over just what their capacity for loss is, and repeat until you reach a range of outcomes that feel comfortable.
Not only are one-year outcomes covered, we also provide a 10-year forward-looking model that gives a much more comprehensive set of outcomes (90% of probable outcomes), calculated by a Monte Carlo Simulation:
Whilst there is no perfect method universally accepted by the adviser community or the regulatory authority, by taking the abstract concepts of risk and marrying them to relatable figures the discussion around finding the ideal balance of risk and return for an investor’s portfolio comes on leaps and bounds. Not only is it an ideal way for advisers to demonstrate the thoroughness of their advice, but it can help to deliver better, more suitable outcomes for their clients.
1Financial Services Authority. Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable
investment selection. GC11_01; January 2011.
2Financial Ombudsman Service. Annual Review 2013/2014. March 2014.
3 Russell Investments. Russell Model Portfolios: Helping you achieve outcomes that matter. January 2014.
4 Accurate to one standard deviation, or 68% of outcomes.
5Russell Investments. Russell Model Portfolios: Helping you achieve outcomes that matter. January 2014.