New Vistas in Risk Profiling

Full Article: New Vistas in Risk Profiling

Summary

Risk profiling is fraught with misunderstandings that lead to ill-advised approaches to determining investment suitability. These include

• using observed behaviour to determine risk tolerance;
• optimising for “behavioural” risk attitudes, rather than helping clients mitigate and control them;
• eliciting risk tolerance on subcomponents of overall wealth;
• using overengineered and unstable approaches for measuring risk tolerance;
• putting far too little effort into understanding risk capacity; and
• using “required” returns as inputs to the investment solution.

To get past these, we need a crystal clear understanding of the crucial distinctions between risk tolerance (an investor’s stable, reasoned willingness to take risk in the long term), behavioural risk attitudes (the unstable, behavioural, short-term willingness to take risk exhibited through an investor’s actions), and risk capacity.

Risk tolerance reflects the level of risk we should deliver for a client over the long term. Behavioural risk attitudes, in contrast, are transient and context-dependent preferences that result in poor outcomes if we mistake them for risk tolerance. They are not attitudes we should want in the driver’s seat for our long-term portfolio optimisation. The role of suitability is to steer investors toward better outcomes, not replicate (and optimise for) all the silly things they do already.

Risk capacity is vital because the risk investors are willing to take might not be risk they are able to take. Risk capacity chiefly concerns investors’ ability to meet future liabilities, so there is an essential connection between risk capacity and both (1) a holistic view of the client’s current circumstances and (2) goal-based investing. Risk capacity is the vital pivot turning information from the wealth planning process into a measure of the appropriate risk level for the investment process.

For most investors, risk capacity is vastly more important than risk tolerance, and yet industry debate unnecessarily centers on how to better measure the latter. Unfortunately, the greater complexity of risk capacity means it is easy for those with vested interests in particular views to obfuscate the debate. A series of simplified investor cases can help strip away this complexity to extract the essential features and exact role of each of the three components. 

If we genuinely want to determine the right amount of risk, it is not sufficient just to measure risk tolerance. It is also not sufficient to supplement this with a narrow model of risk capacity. We also need to help people understand, articulate, and dynamically adapt their future goals, plans, and aspirations over their journey. Effective goal-based investing is necessary to truly find the appropriate risk level.

But the best investment solution is not just about establishing the theoretically “right” solution; at least as important are other behavioural risk attitudes that affect anxiety over the journey. Emotional comfort is never the goal of investing, so portfolio construction should seek to help investors mitigate and manage these attitudes rather than pander to them by “optimising” for them. Often that means moving slightly away from the “best” solution if by doing so we purchase a big reduction in anxiety efficiently and cheaply—that is, with as little deviation from the solution that fits their long-term risk profile as possible. The best solution needs to be bothsufficiently efficient and sufficiently comfortable: Do not let the best be the enemy of the good.

The flip side of the lack of attention given to risk capacity and behavioural risk attitudes is an unnecessary tendency to search for ever more sophisticated ways of eliciting risk tolerance, which are in many cases misguided. The gap lies not in how risk tolerance is measured but in how it is used. A simple, well-designed measure, used well, is hard to beat.

That said, there are promising new vistas using big data, observed behavioural patterns, and machine learning, but these should be used to understand behavioural risk attitudes, not risk tolerance. Profiling should provide an opportunity for investors to learn about their attitudes, emotions, and biases, and in doing so, it should help them prepare for the anxiety of the journey. The more this can be done using investors’ own past behaviour and their specific financial situation and goals, the more effectively it will help them govern their future behaviour.

Possibly the most exciting new vista is not about what is measured; it is about when and how the data are collected and used. Advances in technology, data analytics, and behavioural design can blur current rigid distinctions between profiling,  suitability, and client engagement. 

Every engagement point is an opportunity to enrich the profile. Every change in the profile is an opportunity to sharpen the overall solution. And every change to the solution is an opportunity to identify new valuable engagement opportunities. Risk profiling ideally becomes part of a never-ending dialogue between investor and adviser, constantly updating to changes in circumstances and preferences, creating a profiling process as a digital decision prosthetic to supplement and enhance the essential human side of investing.

To progress, we should focus on developing dynamic models of risk capacity and tools to truly help investors understand and articulate their own goals. We should concentrate much more on how we use this knowledge. And we should stop treating profiling as a point-in-time activity and instead ensure that suitability adjusts dynamically to meet constantly changing needs.

The ultimate new vista in risk profiling is that it becomes impossible to separate from goal-based suitability and from effective client engagement.

Full article is here.