““If you know the enemy and know yourself, you need not fear the result of a hundred battles” Sun Tzu
What is risk?
Risk, in terms of finance fundamentals, involves the chance an investment's actual return may differ from the expected return. Risk includes the possibility of losing some or all of the original investment.
However, risk is not inherently bad and does not need to be avoided totally. A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Simply, investors need to be compensated for taking on additional risk.
A Government Bond is considered one of the safest investments, particularly when compared to riskier assets such as equities, thus provides a lower expected rate of return.
Risk profiling is a process that professional advisers use to help determine the optimal levels of investment risk for clients. Risk profiling aims to identify a client’s level of required return, and therefore risk, to meet their investment objectives; their risk capacity and; their tolerance to risk.
This refers to the level of risk required to be taken on investments to achieve the desired level of investment return
to meet the client’s goals. This expresses a direct correlation to a clients required level of return.
This refers to the level of investment risk or losses that a client could afford to take to achieve their goals.
This is the level of risk a client is comfortable with taking to achieve their goals.
By assessing these aspects of “risk”, it allows advisers and clients to discuss what levels of risk clients need to take to achieve their investment goals, and whether they would be comfortable with the associated level of risk.
By engaging in this process, an investment profile is created. An individual’s risk and investment profile will affect the overall decision-making strategy and process. A risk profile is important for determining proper asset allocation in regards to an investment portfolio.
Types of Risk Profiling
The types of risk profiling, and the process of risk profiling, has evolved and developed substantially in the last 30 years. This evolution can be separated into four broad eras over the 30 years; from a primitive Stage 1 to a sophisticated Stage 4.
We note that risk profiling, on the surface, is still largely questionnaire focused, and based on underlying scores. However, advances in computing power and the psychological understanding of investors have allowed the back end of risk profiling to become more scientific and thus more reliable and appropriate.
The need for Risk Profiling
While it is common and best industry practice to conduct risk profiling, particularly when giving personal advice, some issues concerning advisers and licensee practices have again focused attention on this area of the financial planning advice process. Thus, both clients and advisers need to understand the risk profiling process and the implications on advice and investments of the respective risk profiles.
Additionally, advisers are legally required under the Corporations Act 2001 to have a reasonable basis for the advice provided to clients. Where that advice relates to financial products with an investment component, ASIC’s Regulatory Guide 175 indicates that the ‘relevant personal circumstances’ of the client will normally include their tolerance to risk; thus a risk profile.
The first risk profile questionnaires covered a mix of goals, time horizon, risk tolerance and investment experience. Scoring was rudimentary and arbitrary. Scores were mapped to a set of asset allocations/model portfolios.
This still remains the fundamental basis for risk profiling
More complex questionnaires were used to select an asset allocation/model portfolio for which expected returns were projected against goals.
Projection techniques were rudimentary, but broadly recognised that risk tolerance could be a constraint on what otherwise might be recommended.
The introduction of psychometric risk tolerance testing marked the introduction of science into the risk tolerance assessment process.
This made the risk profiling process a discussion topic, rather than a pure compliance tick box.
Risk capacity was introduced into the mix as a separate constraint evaluated through stress-testing in modelling software.
Advances in technology and computing power allowed for smarter risk profiling and benchmarking.
Note: This article is intended to provide general advice only, and has been prepared without taking account of your objectives, financial situation or needs, and therefore before acting on advice contained in this document you should consider its appropriateness having regard to your objectives, financial situation and needs. If any advice in this document relates to the acquisition or possible acquisition of a particular financial product, you should obtain a copy of and consider the Product Disclosure Statement for that product before making any decision.