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Risk Profiling: From Regulatory Imperative Towards Client Education

Emma Rees

22 October 2007

Traditionally, client risk profiling has been seen purely as a regulatory imperative. Increasingly however, finding out clients’ appetite for risk is becoming a much more subtle and sophisticated process. By developing an approach to risk profiling in close co-operation with client relationship managers, wealth management firms are achieving a better understanding of clients and, as a result, enhancing their relationships with them. UK private bank Arbuthnot Latham introduced its client risk profiling questionnaire around 16 months ago. Developed in conjunction with Ibbotson Associates, it is investment management led. “We wanted to understand the impact of changing the wording of a question on the results”, says David Kidd, chief investment officer, Arbuthnot Latham, the private banking arm of Arbuthnot Banking Group. “We tried to remove our own prejudices from the outcome, which meant completely excluding references to assets classes.” UBS’s risk profiling questionnaire has two elements; the first aims to understand the client’s emotional response to different risk scenarios and the second looks at comfort with different types of investment, particularly non-regulated asset classes: ”We want to clearly understand what a client means by risk and how they define it”, says Gavin Rankin, head of products and services consulting for UBS Wealth Management, “whether this is by volatility, how much they are prepared to lose in any one year, how they would feel if they incurred losses two years in a row and so on. We want clients to understand the choice of asset classes so that the spread can be diversified across as broad a range of asset classes as possible.” Guy Paterson, UK chief executive of the Family Investment Office at Unigestion, believes that it’s impossible to spend too much time determining a client’s real appetite for risk: “If that’s wrong, everything else will be wrong”, he told WealthBriefing. Unigestion uses both conventional risk profiling techniques and an optional psychometric test which aims to identify how much a client’s fundamental risk tolerance has been influenced by experience: “Our more conventional risk profiling aims to make it easy for clients to form a view about where on the spectrum of risk they are by looking at maximum tolerance for losses, real statistics and track records. The last ten years has been a useful period from which to draw examples as it has included raging bull markets, vicious corrections and a strong recovery.” Unigestion’s psychometric test was developed five years ago by Professor Munier, who is retained by the French Government to assess risk in the nuclear industry: “We wanted a different view on risk”, says Mr Paterson. “Those who have experienced losses tend to be more sensitive on the downside and at the end of a good bull market, investors can become indifferent as they don’t think that losses are going to happen. Psychometric tests can sound scary, but are enormously helpful in determining true appetite for risk. Our test constitutes a series of questions which have nothing to do with recent market experience. This gives rise to chart print outs and produces a pattern of responses which can be compared with the conventional risk profile, indicating if a client’s underlying appetite for risk has been skewed.” Mr Kidd says that Arbuthnot Latham’s questionnaire asks similar questions in a different way: “We are looking for consistency as it denotes understanding. If clients don’t answer the questions in a consistent way, it may mean they have two pots of money, or that they’re confused. Clients often say they need income when what they mean is they are defining their spending requirements. Either way it’s a chance for further dialogue with the client and a means of ensuring we start on a sure footing”, he says. A resulting score places the client on a graph of risk versus return where their best return for their risk profile is indicated at, say, 8, 10 or 12 per cent: “To some clients it is straightforward”, says Mr Kidd, “but others who have not invested in the stock market before might be surprised that they can only expect 8 per cent return, for the level of risk they are willing to take.” Gaining a client’s perspective on risk is just one element of Rothschild’s Investment Questionnaire, which is structured to determine other information about the client such as their overall position, time horizon and need for income. Dr Scott Ingham, strategic asset allocation director at Rothschild, says that the final section of its questionnaire often provides the greatest insights: “We ask clients about their approach to investing; whether they see themselves as having a high or low appetite for risk; their attitude towards inflation; and what level of losses they would be prepared to tolerate in a market downturn”, he says. “This provides a means of teasing out discrepancies between the client’s understanding of their own tolerance for risk and how we view it. Warren Buffet said, “diversification is protection against ignorance and where a client’s approach may appear high risk to us, it can be low risk to them, perhaps because they have huge self-belief.” UBS says that if a client has a positive response to seven asset classes and volatility, it might propose a seven asset class growth portfolio: “This is presented to the client along with the appropriate risk characteristics and is stress-tested, showing the consequences of different risk scenarios on the portfolio and how it performs in different circumstances”, says Mr Rankin. Whilst Rothschild says that it is quite possible for two clients to have the same asset allocation, it is how asset allocation is fulfilled that is key: “You would implement the same asset allocation using different investment vehicles for clients with different levels of assets or for those that have a specific income requirement for example”, says Dr Ingham. He goes on to say that Rothschild’s questionnaire is just one tool that is used to stimulate conversation with clients and what happens on completion is not formulaic: “We always bring it back to the client and ask them whether what we have come up with gels with what they thought. It’s all about expectation management and explaining to clients the relationship between risk and return.” So what happens when a client’s desire for returns and appetite for risk don’t match up? “It often happens that clients want 10 per cent per annum returns and no risk, so the ensuing discussion is often an educative process”, says Mr Rankin. “If the client’s attitude to risk and desire for returns are not aligned, we would communicate the value of diversification and explain that they can take on riskier assets for example, but less volatility.” Dr Ingham says that clients tend to have an asymmetric tolerance for losses: “By this I mean that if the market goes up by 25 per cent, they expect their portfolio to be up by at least as much. However, if that market falls by 25 per cent, they would only want to be down zero. And it’s not just about appetite for risk as a client might have a high risk tolerance, but an income requirement, which would change the way their portfolio is structured.” According to UBS, high net worth individuals tend to target absolute returns rather than chasing benchmarks. They have worked hard to earn their money and prioritise capital preservation: “Of course there is a spectrum of clients and some are comfortable with some significant degree of risk. Many adopt a core and satellite approach, where the majority of their portfolio is as per their defined risk allocation, but a proportion is used for a more high risk, thematic approach”, says Mr Rankin. “On a scale of 1-6, with 6 being the most risky, most of our clients are between 3-5, so slightly more towards the riskier end of the spectrum”, says Mr Kidd. “In the marketplace as a whole, you would expect to see a normal shaped distribution curve, but perhaps our clients’ experience gives them a propensity for a higher risk tolerance”. Unigestion’s Mr Paterson believes that the danger for investors at the moment is that many have not seen a proper correction as there has only been one 10 per cent correction in the last four years: “With early stage investing, we are extremely sensitive to feedback and can detect how a client is reacting. Risk profiling is not a one-off but a constant exercise”, he says. “Our clients’ risk profile hasn’t changed a great deal in the recent market hiatus as we share a clear understanding with them and they are relatively well conditioned. It’s more a case of constantly communicating with clients and checking that there are no banana skins.” According to Mr Kidd, in light of recent volatility a number of clients ask whether the risk tolerance they exhibited in the questionnaire still stands. “We reassure them that it should, but if they in are in any doubt, we are happy to revisit it with them.” Dr Ingham describes determining client needs and expectations as a journey: “It’s an ongoing process and one where we can make modifications at an asset allocation and security level. If the road’s too bumpy for a client and they start to get car-sick, we can always go down a different road.”