Accurate risk profiling of clients is a key element in the advice process and Parmenion has assisted Advisers for some time with this process through the use of our well established Risk Profiler.   Earlier this year, in our endeavours to constantly improve our service to you and your clients and having given careful consideration to the FSA’s guidance on Assessing Suitability, Parmenion took the opportunity to have its Risk Profiler independently reviewed by international business psychology consultants, Edgecumbe Consulting.  

This exercise proved extremely valuable, not only providing comfort that the existing questionnaire was fit for purpose, but also to ensure that our Risk Profiler was as intuitive as possible, helping clients to answer questions in a way that most accurately reflected their attitude to risk.  The end result is a new and expanded version of the Risk Profiler that incorporates feedback from Edgecumbe Consulting.

What is risk?

Investment is all about risk.

The return from any investment is the economic reward you hope to receive for accepting a certain degree of risk. The reward paid by a riskier investment is expected to be greater because the possibility of losing some part of your investment is greater; willingness to take a risk is therefore balanced by the chance of a greater payout.

Ability and willingness to accept risk are, by far, the most important factors in determining long term investment returns. A high return portfolio simply cannot be achieved without accepting a higher possibility of loss, but this is often clouded by the ‘need’ to take risk to achieve a certain goal. It is therefore important that the need to create returns is balanced with a clients’ appetite for risk. While the relationship between risk and reward is a clear one, individuals’ sensitivity to risk and their capacity to accept it can vary enormously. The skill of the adviser is in drawing out the various elements that make up this very complex picture and making suitable investment recommendations. It requires professional expertise to assess clients’ responses and whilst risk profiling is not an exact science, using a well-designed risk profiling tool can give demonstrably consistent and coherent outputs, which are an important contribution to the Know Your Client process.

How does risk profiling inform the client advice process?

A structured approach to assessing the Risk Profile of individual clients is important when it comes to maintaining a high standard of advice.

Assessing a person’s risk profile involves striking a delicate balance between measures of their tolerance, risk perception, capacity and requirements. While it is tempting to try to match a suitable asset allocation and investment portfolio to a client in a single step, this is rarely possible. Built into this process should be enquiry into a number of additional inter-related behaviour factors such as; knowledge – the more financial and investment knowledge, generally the more willing to accept investment risk, comfort – some personalities are more willing to accept risk for ‘thrill’ or ‘opportunity’, choice – preferences for a certain type of investment and regret – a negative emotion from making the wrong decision and we already have a very potent mix of factors that determine individual risk profiles. Taking the time to understand the underlying structure of a client’s attitudes to risk can help form a clearer picture of the psychological as well as financial needs they have.
 
Asking your clients to complete the Parmenion Risk Profiling Questionnaire tool will help them to think about their own risk tolerance and the various risk elements that contribute to it. The risk profiling questionnaire tool should mark the beginning of a conversation, and is one of the earliest steps in the advisory process. This will be followed in the Client Advice Process by the detailed personal fact find, a review of investment options and the issue of a Suitability Report, which can be supported with the Parmenion Investment Management Report (IMR). The IMR is created during the on-line Investment Selection Process.

Guidance from the FSA

The FSA has conducted a study of how advisers and investment professionals have measured and recorded their clients’ attitudes to risk and found some significant issues. To address these shortcomings, the FSA has issued guidance in 2011, Assessing Suitability: Establishing the Risk a Client is willing to take and making a suitable investment selection. The key findings from the FSA are:

• Advisers need to collect and properly account for all the information relevant to assessing the risk a client is willing and able to take.
• Placing reliance on risk profiling and asset allocation tools is not an alternative to the exercise of professional judgement.
• Descriptions of attitude to risk can be misleading. Attaching asset allocation to risk profile requires care and should be based on a complete picture of the client’s objectives and financial position.
• Undue focus on the risks a client is willing to take, as opposite to those they need to take, can produce inappropriate advice.
• The adviser must understand the risks associated with the assets selected for clients.
• The use of tools must be undertaken responsibly and not leave the client exposed to poor advice. The above should not be considered a substitute for reading the full guidance paper which can be found on the FSA website.

A key part of Parmenion’s response to the FSA’s guidance was to engage Edgecumbe Consulting to make an independent assessment of our Risk Profiling Tool. The conclusions of this review have been produced in a report for Advisers entitled: ’The Parmenion Risk Profiler – A Psychometric Review’ which is available to Advisers registered with Parmenion.

All the questions have passed suitability screening and have been signed off as ‘fit for purpose’ by Edgecumbe Consulting and screened by a control group of individuals. We have created the Parmenion Risk Profiling Tool to help you assess risk with your clients and understand their true risk profile in order to help you comply with the FSA requirements.