Risk Profiling: A Good Friend Indeed

Ken Kivenko The Know Your Client (KYC) process is one of the most fundamental obligations under securities legislation and one of the most important elements of investor protection. A key part of the KYC /suitability regime is the assessment of an accurate client risk profile. The number one cause of investor complaints and client dissatisfaction is unsuitable investments, and the primary cause is a defective client risk profile assessment either due to incompetence, negligence and/or lack of a process standard. No matter whether or not a best interests’ standard of advice is adopted, an improved risk profiling approach is vitally needed.

Risk profiling is a process for finding your optimal level of investment risk considering the risk required, risk capacity and risk tolerance, where:

Risk required is the risk associated with the return required to achieve your goals from the financial resources available. For those who have accumulated significant savings, purchasing riskless Canada Savings Bonds may be the solution, so NO risk is required;
Risk capacity is the level of financial risk you can afford to take without disrupting your financial plans; and,
Risk tolerance is the level of risk you are not uncomfortable with.

Defining your personal risk profile will allow you to build a portfolio that has a risk-reward ratio most suited to help you reach your goals. The self-awareness about risk it creates and the improved relationship between you and your advisor offer significant added value.

Establishing portfolio asset allocation targets (with due consideration of taxes) is one of the most important determinants of portfolio return and associated risk. But risk tolerance is just one dimension. A complete risk profile should include more than just an evaluation of how much risk you prefer to take (risk tolerance). It also must assess how much risk you can afford to take (risk capacity) and how much risk is needed to achieve your investment goals. A rational decision would involve taking only as much risk as is necessary to meet financial goals.

In some cases, there is a difference between the risk you are willing or able to take and the return you expect; this can result in an advisor assessing risk tolerance higher than it should be in an attempt to meet your expectations. Risk profiling attempts to identify and correct such disconnects before investment decisions are made.

How we perceive risk varies from person to person, and generally depends upon: portfolio objectives, age, employment and marital status, annual income, accumulated savings/Net Worth, savings rate, time horizon, size of your emergency fund, general investment knowledge, debt load, and the critically important behavioural profile. This latter point is where big opportunities for improvement exist. Risk itself is generally categorized by its likely impact or magnitude if the uncertain event happens, as well as its frequency or its probability of occurring. The most common client interpretations of risk include the fear of an outright loss of capital, the fear of not having enough for retirement (or other life goal) and the fear of running out of money while in retirement.

UK securities regulators have been leaders in risk profiling. In March 2011, they released Assessing suitability: The risk an investor is willing and able to take and making a suitable investment selection http://www.fca.org.uk/static/documents/final-guidance/fsa-fg11-05.pdf. In Canada, investment dealer risk profiling is characterized by significant deficiencies. For years, regulators, the courts, OBSI and investor advocates have identified numerous concerns with respect to NAAF/KYC information being collected by dealers and how it is used. The consequence of sloppy profiling is deficient investor protection, especially for seniors/retirees, a growing demographic. There is a crying need for a standardized industry form and a standard, meaningful risk profiling process.

Some examples of prevailing risk profiling system deficiencies:

Failure to consider the three risk factors (tolerance, capacity and need) separately and assigning inappropriate weightings to the risk factors;
KYC information is inconsistent and unreasonable (e.g. a client with a speculative investment objective and a low risk tolerance or a high risk tolerance but a low capacity for loss). Most dealers don’t seem to have information systems and other controls to prevent and reconcile such inconsistencies;
Use of the same risk tolerance for different accounts with varying timelines and goals;
Little or no meaningful explanation of terms used on the NAAF, including Risk tolerance, investment knowledge and time horizon (long term: 5 years? 20 years?);
Use of calculators or other formulas that focus on the client’s willingness and ability to accept risk rather than the capacity to withstand losses;
Dealers may record risk tolerance either as a number or range of numbers without providing explanation of what the number means or how it was derived. There is no explanation of what, say, “medium risk” means in terms of how it will relate to the types of securities that will be sold to you;
Where the so-called model portfolio approach is used, little or no disclosure to the client regarding the composition of the portfolio, how the portfolio was selected and no statistical analysis to support its reasonableness;
Assessment of the risk of individual transactions rather than the risk of the portfolio;
Where questionnaires are used to assess risk tolerance, the end determination of the client’s risk tolerance is too often greater than what the responses from the questionnaire suggest. [In July 2014 the Mutual Fund Dealers Association of Canada (MFDA) published a Discussion Paper (http://www.mfda.ca/regulation/bulletins14/Bulletin0611-C.pdf) on the use of investor questionnaires to improve the Know Your Client (KYC) process. The Sample Investor Questionnaire attached to it was developed through extensive research and thorough investor testing.]

Besides the basic defects in the NAAF form design and its interpretation, there are other major issues that retail investors should be aware of. These include but are not limited to the following:

The NAAF form is filled in and signed by the advisor and not given to the client for review
The client is asked to sign the form, leaving the blanks to be filled in by the advisor.
The form is filled in by the client and changes are subsequently made without authorization by the client. In some cases, NAAF information may either be missing, incomplete, illegible or unsigned/undated yet progresses through the system. Never sign blank forms and be sure to periodically ask for a copy of your KYC.

In a January 2010 research paper entitled Beyond Risk Tolerance: Regret, Overconfidence, and Other Investor Propensities, researchers Carrie Pan and Meir Statman, using historical asset class return data and results of multiple investor surveys, concluded that:

Client risk tolerance is compartmentalized, with “subtolerances” relating to distinct goals such as children’s education, retirement and extravagant self-indulgence. A segmented portfolio related to client goals/subtolerances may be more satisfying than an aggregate portfolio derived from global risk tolerance;
Translation of client risk tolerance measurements into portfolio allocations often follows opaque rules of thumb. A quantitative linkage of risk tolerance to portfolio risk-return expectations may enhance satisfaction;
Client risk tolerance tends to rise (fall) after high (low) market returns. Explicit accounting for this bias may enhance satisfaction;
Client risk tolerance in foresight may be lower than risk tolerance in hindsight, to varying degrees for different individuals. Assessing and adjusting for client tendency to feel regret may enhance client satisfaction;
Client propensities for trust and overconfidence may distort measurement of risk tolerance. Assessing and adjusting for such propensities may enhance satisfaction.

Thus, financial advisors may be able to improve client satisfaction and outcomes by refining the typical approach to risk tolerance measurement and accommodation. In principle, Do-It-Yourselfers can apply such refinements to themselves.

In theory, a high-potential, high-volatility portfolio should generate better returns over time, but it has to match up with your psychological makeup. Too often dealers develop scripted programs with all the required exercises, but fail to take into account your time, willpower and historical investment behaviour. That is why volatility of returns along the investing path plays a big role in determining outcomes. For example, it has been observed that owning a slightly pricier balanced mutual fund, rather than separate Equity and Bond funds, yields better long-term results for investors. Effective customized risk profiling can help design portfolios that should deter you from panic selling during an inevitable market correction or chasing returns during a market boom.

When you fill in or update a New Account Application Form (NAAF) you are asked to state your risk tolerance that leads to recommendations. In transaction environments, there is no real structure and discipline underpinning recommendations and no responsibility to ensure that there is one. The imperative is the transaction and not the process. Some advisors rely on “scores” derived from answers to questionnaires that assign numerical values to the responses and mechanically assign the resulting tallies to asset allocation tables. If this assessment is incorrect, you may find your advisor makes recommendations that are unsuitable for you. If you incur losses and file a complaint, whatever risk tolerance you ticked off on the NAAF/KYC form can and will be used against you by the dealer. It is also crucial that you clearly articulate the goal(s) for your investments. Without timelined, defined goals; assessing the appropriate level of risk is virtually impossible and meaningless.

In Canada, there are no industry standards in place for how a risk-tolerance assessment is to be conducted and documented. The scoring typically is rudimentary due to inappropriate weighting of the simplistic risk factors isolated in the questionnaires. Moreover, there may be no analytical basis for concluding that the questionnaire’s design will extract valid information about your true willingness, capacity and need to take investment risks. Indeed, some dealer questionnaires may have a built in bias towards riskier (and more expensive) investment products.

Your advisor needs to identify any disconnects between the three measures of risk and help you make trade-off decisions to tailor the portfolio construction/asset allocation and risk level to your goals. A frank discussion is therefore important. A disconnect may indicate that your investment goals are unrealistic. In such cases the goals need to be revised, the savings rate increased, retirement deferred and/or the risk and potential adverse consequences consciously accepted.

While risk profiling is neither easy nor exact, it needs to be done. Just testing out some of the many questionnaires available on the Internet can be very helpful in raising your consciousness and knowledge concerning risks and your attitude toward risk.

Here’s a good one to try http://www.riskprofiling.com/WWW_RISKP/media/RiskProfiling/Downloads/Questionnaire_CANEN.pdf

Also, read this paper on investor risk profiling from Vanguard. It will open your eyes and make you a better, more confident investor. https://www.vanguard.co.uk/documents/adv/literature/investor-risk-profiling.pdf

Risk profiling can assist in constructing a tailored risk-reward portfolio but will not deal with other factors that can drain accounts. These include advisors who lack the proficiency to map a portfolio consistent with the risk assessment, advisors who recommend high fee/tax-inefficient products or inappropriate leveraging, and outright advisor fraud.

The evidence points to a need for an effective and uniform practice standard (and proficient advice givers). Risk profiling is integral to the investment process. It underpins decisions about portfolio construction, and plays an essential part in ensuring the suitability of investments. Risk profiling improves the quality of advice and brings added credibility, communication and rigour to the investment advice offered. At the same time, it would also help advisors and dealers reduce their exposure to client complaints, restitution claims and disciplinary proceedings. Improved communication will enhance consumer protection by reducing the incidence of unsuitable recommendations stemming from inadequate risk profiling and thereby improve client financial outcomes.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com