Ethical Risk Profiling
Dr Katherine Hunt
????♀? Surfer | ??? Professional Speaker | ????♀? Researcher | ?? Ethical Growth Authority | ?? Non-Executive Director
Your clients are exposed to investment risk no matter what you do. It’s not necessarily a bad thing. Risk and return trade-off and all that.
All portfolios and all assets hold a certain degree of ‘risk’ (define this word as you would prefer) ….
And ….
All clients have a unique risk profile ….
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Then it is logical that risk profiling takes center stage in the advice process.
It’s the archaeopteryx between the reptiles and birds (if you’re a biology nerd).
Or it’s the vital linking piece between a client and the right investments for them.
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In my opinion, we are lucky that the legislation doesn’t dictate some specific process to understand a clients risk profile. In fact, the risk profile legislation basically says that we just need to follow a process. ‘A’ process. That’s all.
Which means that everything we actually do in risk profiling is a discussion on ethics – not the law.
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Ethics goes over and above the law. As does every single risk profiling process.
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So let’s have a look at risk profiling.
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The academic literature seems to say there are three components (but their weighting has started wars and feuds before, some still raging):
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1.?????? Psychological Tolerance for Risk
You have a unique tolerance for risk (or aversion against loss) that is different from mine. And kind of unsurprisingly, you are likely to take similar amounts of risk in different parts of your life. So if you like racing motorbikes and surfing shallow reef breaks, there’s a good chance you also don’t mind a bit of risk in your investment strategies or products. It’s not always like that, but chances are ….
There are a couple of ways to figure out your psychological tolerance for risk. We could simply ask you (you probably know). Or we could ask you in lots of weird ways relating to gambling and fictional inheritances and whatnot. Or we could give you money and force you to gamble with it (this is called revealed preferences).
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If the youknowwhat hits the thingamabob, this is arguably the most important component. Or the only component really – it’s the client’s ‘feeling’ of mismatch between them and their investment outcomes that drives AFCA claims. It’s the clients ‘feeling’ of mismatch that has the potential to build an empowering relationship, or not.
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2.?????? Risk Capacity
Your cold hard quantitative capacity to take risk is a calculation that determines if you can ‘bounce back’ from financial shocks or not. The factors that indicate you could bounce back include your income earning ability, and your money. Aka Human capital, and Financial capital.
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Human Capital
No offence to the elders at this party, but human capital decreases as we age. Good news for the nerds, it increases with the number of degrees you have, and with your level of seniority in your firm. And the main determinant of human capital is years to retirement. Hence why it decreases as we age.
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Financial Capital
Good news for the elders at this party – I can almost guarantee that you are richer now than you were at age 20. Nice work. In general (and we hope), we accumulate more financial resources as we age. This factor could be something like ‘net wealth ex-home’ or similar. A simple way I determine this is the calculation: (your net wealth ex-home) / (your retirement income) ?= (if you’re above 10, you’re doing epic)
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3.?????? Risk Needed
If you asked anyone who had any finance education or training, this would likely be the most important component of risk profiling. CIMA and CFA legends, I’m looking at you. This is the amount of risk/return needed to be taken based on the timeline of that particular goal.
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So there are three components to risk profiling:
What should the weighting be between the three risk profiling components? 33/33/34?
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Love this topic and want more?
Owner, Waterfall Way Associates
1 年I prepared an internal paper on risk tolerance back in 2020 and came up with a four dimensional paradigm :
Associate Adviser | LinkedIn Networking | MFinPlan Candidate | Posts about Wealth Building Strategies, Strategic Investment Growth, Tax Effective Retirement Planning, Securing Cashflow Acceleration
1 年Great insight on this, thanks for sharing. Reminds me from Kahneman's 'prospect theory' just how much perceived risk drives everything else in advice and construction.
Specialist Wealth Adviser
1 年Thanks for your thoughts on this matter Katherine, but I disagree that ‘All Clients have a Unique Risk Profile”. I would submit, all clients have a unique risk profile for a particular matter - based on their goals and objectives. I client may have a ‘high’ risk profile associated with the investment of their superannuation portfolio and associated monthly contributions with a 20 year investment horizon, and a moderate risk profile asssociated with the investment of the lump sum sales proceeds of a home - where the investment time horizon is expected be 3-5 years. This idea that a client has one risk profile is the source of much confusion in the profession and with regulators including ASIC and AFCA
Degree Completed
1 年Risk Profiling more floors than the Empire State Building !
Head Of Research at Padua Solutions
1 年Psychological risk profiling should not be a static or one-time process but rather a dynamic and ongoing one but due to the limitations of the conventional business model, this is not the case. Therefore, advisers who specialise in this area need to adopt a more holistic and flexible approach. This may require the use of technology and a shift in the role of advisers, who may focus more on building and maintaining relationships with their clients. This may also imply a change in the business model of advice, from a transactional to a subscription-based one. Ethical advice perhaps is best addressed using a "private banking framework", relying on a team of experts, to help the client rather than a traditional transactional model.