Financial planners know that understanding client attitudes towards risk is a key step in helping them meet their investment objectives.
Clients often lack a solid understanding of financial risk, and an initial review by CoreData UK of some investments held by clients and mapped against their objectives proves this to be the case.
For example, one UK adviser revealed a new client with a conservative appetite to risk was actually invested in a highly volatile technology fund.
Asked how it fitted with the client’s expressed aim of avoiding undue risk, the client said he had seen it recommended in a newspaper, so assumed it must be a low risk fund.
This reveals a touching faith in the perception of media wisdom, but also a lack of understanding of the risks of holding a potentially volatile single sector fund.
Meanwhile another adviser recalled explaining the relationship between risk and reward to a client and how they are interlinked.
When he then asked the client what balance of risk and reward he thought he wanted, the adviser was somewhat taken aback to be told: “Maximum reward with no risk, please.”
Despite this information chasm in the above cases between adviser and client, risk profiling is being used increasingly to help clients and advisers reach a better understanding of risk appetites.
As well as assessing risk in terms of where clients are most comfortable on the spectrum of investment options, risk profiling can also look at individual’s underlying emotional view of risk.
This latter approach may use methods such as psychometric testing or questionnaires that put risk into non-financial terms, which clients can more easily understand.
From this, a key finding could be how much an individual’s attitude to risk is shaped by their experiences.
Individuals who have experienced market crashes are generally more sensitive to the risk of falls in their investments, for instance.
A greater understanding of risk has also been developed by the UK’s pension funds.
A decade ago, like the ‘maximum reward, no risk’ client above, many schemes gave investment managers a brief of seeking good returns without too much risk.
Now, consultants are more likely to calculate the risk budget of a scheme and what risks it is currently exposed to, as a way of producing a more rational investment policy.
As a result, pension funds now try to make the most efficient use of their risk budget and seek to minimise or manage any unrewarded risks they face.
For ordinary investors, these more sophisticated approaches may trickle down in time.
At present, classifying investors into boxes such as low, medium or high in their risk tolerance levels may satisfy the regulator, but it is not at the cutting edge of managing risk.
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