Understanding the risk profile of a client is an important prerequisite of any advisory engagement. In fact the regulatory body for investment advisors in India, SEBI, mandates that advisors must put every new client through a thorough risk profiling process before initiating an advisory engagement with the client. And most regulatory bodies that watch over financial and investment advisors in different countries across the world mandate the same in some way or form. Therefore every advisor would have their own risk profiling tools which they would use to gain an understanding of a client’s risk profile. And from there, the advice imparted to the client is almost completely built around the results of each client's risk profiling exercise. This is something that is once again mandated by SEBI and most other regulators. So, risk profiling and the use of risk profiling assessment tools are an essential aspect of every advisory engagement. But there are certain inherent flaws with the way most risk profiling exercises are carried out and completed in the present moment. This automatically means that advice delivered on the back of them is highly likely to have limited positive effects. This clearly indicates the need for a change in the methods used by advisors to collect information on the risk profiles of their clients, and the way in which that information is utilised over the course of an advisory engagement. Therefore today’s post will focus on how information on risk profiles is presently collected and utilised, and then show how these methods can be refined and improved.
To define it simply, a client’s risk profile gives insights into the way they perceive and understand investment risk, and how those perceptions influence their investment decisions. A risk profile assessment helps advisors match the degree of risk that a client can afford to take, with the degree of risk they are willing to take. This therefore helps advisors understand how much risk a client needs to take to achieve their financial goals, thereby helping them design investment strategies that are specifically suited to each client.
A typical risk profile assessment that a prospective client currently undertakes usually consists of a set of multiple choice questions on aspects such as their age, income, number of dependants, investment experience and so on. It may also include situational analysis where the client is given hypothetical situations and given a set of alternatives as to how they would react to each situation. Each alternative response to the questions and situations that form part of the risk assessment are usually assigned a risk score ranging from low risk to high risk. The cumulative score across all the client’s responses is computed and used to judge the client’s risk profile.
But there is an inherent problem with most risk profiling tools that offer alternatives and allow time for the client to think. Firstly, responses to risk profiling tools can never give advisors a holistic understanding of a client’s risk profile. The responses only show the client’s perceptions of risk in light of the events prevalent in their lives at the time they respond to the given risk profiling tool. For example, a prospective client who is open to taking on a moderate level of risk under normal circumstances, may respond to a risk profile assessment tool in a way that indicates a severe aversion to risk, if they have lost their job in and around the point of time at which they respond to the risk profile assessment tool. On the other hand, an otherwise risk averse investor may respond in a way that indicates a high level of risk tolerance, if they are responding in the middle of a sustained upward phase in the stock markets. Also, because the client can think before responding, there is a possibility that they may not be completely honest with their responses. Therefore, reliance on such risk assessment tools must be reduced.
Advisors looking to understand a client’s risk profile would gain a lot more by having heart to heart, open ended interactions with clients at regular intervals about the way they manage their money. In fact, the best way for advisors to gain a more realistic understanding of their risk profiles would be to objectively assess the way they handle every major event that has a direct impact on their finances in real time, over the course of the engagement with the client. Accordingly, the advice that is imparted can be adapted and modified as the advisor gains a better understanding of the client’s risk profile. Also, instead of asking a client to take a risk assessment test just once before the start of the engagement, they must be made to undertake one whenever there is an event that could significantly impact their risk profile. This could include events such as marriage, starting a family, switching to a better paying job and so on. Doing this would mean that advisors would have a clear idea of how a client’s risk profile evolves over the course of the engagement.
But the issues with risk profile data do not end with the way in which the data is collected. Once the data has been collected, it is also utilised inappropriately on a number of occasions. Most advisors tend to base their advice too rigidly on the risk profile of a client. This makes a massive difference when a prospective client has a risk profile that is either overly conservative or overly aggressive, and has financial goals which fall due over varying time frames. For example, let's say that an investor with a conservative risk profile wishes to plan for their retirement. If the advisor were to be overly reliant on the risk profile assessment of the client, the most likely course of action that would be suggested is a portfolio heavily allocated to bonds and other fixed income products. While such a strategy may be adequately palatable for the client to follow, it does not change the fact that planning for retirement is a long term goal which requires a significant allocation to risky assets such as equities, which would facilitate portfolio growth over the years. Naturally, a portfolio that is almost entirely allocated to bonds and other fixed income assets would ultimately impair the client’s chances of having a comfortable retirement. Therefore while adhering to a client’s risk profile is important, due consideration must also be given to the nature of the client’s financial goals while imparting advice. In fact, once advisors gain a reasonable understanding of a client’s risk profile, they must work on orienting the client towards accepting a moderate level of risk, regardless of whether the client’s risk profile tends towards being too aggressive or too conservative. Following such an approach would ensure that clients are always comfortable following the investment strategies suggested to them. It would also give clients a much better chance of achieving their financial goals, regardless of the time horizon of each of their goals.
Even with all these inherent drawbacks risk profiling cannot be circumvented or avoided completely. It will continue to remain relevant as long as it remains a mandatory regulatory requirement as part of an advisory engagement. But the broader takeaway from here should be that the way in which risk profiling is carried out needs to evolve. Methods used for risk profiling need to go beyond being rigid and based on reactions to providing for an element of real time analysis of a client’s risk profile. A great way to do this would be to have an open ended interaction with the client after they have taken the risk profile assessment to discuss their responses to the tool given to them. Clients may be asked why they responded in the manner that they did to certain important parts of the risk profiling tool. This would help advisors understand how well thought out a client’s responses are. It would also help them assess how honest a client has been with their responses. Also, the results of the risk profile assessment must never be given more importance than is due. In other words, the results of a client’s risk profile assessment must be used as a point of reference and not as a Bible when devising investment strategies for them. A client’s risk profile must simply be one among a number of factors and considerations that ultimately decide the optimal investment strategy for their needs and goals. This is the best way for advisors to use client risk profiles when advising them, so as to ensure the most rewarding advisory experience for both the client and the advisor.