Risk Profiling is not an exact science
For advisers, making an accurate assessment of a client’s risk tolerance can be a challenge because of the intangible nature of attitudes, values, motivations and preferences it entails; and because of the potential for miscommunication when discussing such intangibles.
Patersons has designed a questionnaire, which also utilizes psychometric testing and advisers knowledge of clients, to determine and assign risk profiles and attribute risk tolerance to the clients.
A Risk Profiling example
In order to provide clients with the most appropriate advice, Patersons has adopted an online assessment which consists of 26 questions and assesses risk capacity, risk tolerance, financial objectives and current financial circumstances. It would likely take only 10 to 20 minutes for a client to complete.
On completion, clients are then provided with an illustrative tool showing their respective risk profile, its definition and a sample portfolio made up of growth and income assets.
The main purpose of this is to give the client a better understanding of their risk profile and the appropriate levels of risk which should be considered when constructing a portfolio.
The science of measuring mental capacities and processes.
Psychometric testing is any method, whether in the form of a questionnaire or behavioural study, that assesses an individual's psychological profile. In the context of financial advising, a psychometric test assesses a client’s psychological acceptance of risk in pursuit of an investment objective.
Risk Profile definitions
Patersons has adopted six distinctive risk profiles, ranging from conservative (or risk adverse) to very aggressive (or a risk neutral). The former would likely seek to conserve wealth in lieu of capital growth, while the latter may seek financial gain irrespective of the risk associated with the investments.
Interestingly, those with a shorter investment horizon, or with a lower capital pool, may be on the more conservative end of the spectrum. While, larger levels of risk may be appropriate for those with a longer investment horizon and a larger proportion of ‘disposable’ capital.
Cyclical risks exist because the broad economy has been shown to move in cycles; periods of peak performance followed by a downturn, then a trough of low activity. Thus investments are prone to experience a period of negativity. Cyclicality therefore plays a large role in the time horizons attributed to risk profiles. An investor who has a shorter investment timeframe may not be able to ride out the troughs of the market and thus is recommended to be more conservative; while an investor with a longer investment horizon can afford to take more risk and ride out the shorter-term market cycles.
|This suits investors with a minimum two-year timeframe or those that seek a portfolio comprising mainly of interest bearing assets. This portfolio suits investors who give a high priority to the preservation of capital and are therefore willing to accept lower potential investment performance, hence the 85% exposure to defensive assets (cash and fixed interest).
|This suits investors with a minimum three-year timeframe or those who primarily seek income with some potential for capital growth. This portfolio also suits investors seeking a low level of investment value volatility, and therefore willing to accept lower potential investment performance, hence the 70% exposure to defensive assets (cash and fixed interest).
|This suits investors with a minimum five-year timeframe or those who seek both income and capital growth. This portfolio suits investors who desire a modest level of capital stability but are willing to accept moderate investment value volatility in return for commensurate potential investment performance, hence the 50% exposure to growth (shares and listed property) and 50% exposure to defensive (cash and fixed interest) assets.
|This suits investors with a minimum seven-year timeframe or those who are willing to accept higher levels of investment value volatility in return for higher potential investment performance. Some capital stability is still desired, but the primary concern is a higher return, hence the 70% exposure to growth assets (shares and listed property).
|This suits investors with a minimum nine-year timeframe or those who are willing to accept high levels of investment value volatility in return for high potential investment performance. The 85% exposure to growth assets (shares and listed property) means that capital stability is only a minor concern.
|This suits investors with a minimum ten-year timeframe or those who are willing to accept very high levels of investment value volatility to maximise potential investment performance. The 100% exposure to growth assets (shares and listed property) means that capital stability is not a consideration.
Products and respective risks
Risk profiling is the first step in the portfolio construction process. However, just because a client may be in a conservative or very aggressive band; not all products may be appropriate for their individual circumstances.
Products such as synthetics, derivatives, highly leveraged investments and low liquidity and speculative equities should be considered as particularly risky. Thus, clients and advisers need to consider the individual risks of the products recommended and included in an investment portfolio.
Risk profile should not just be used as a check box exercise, or used as a be all and end all test for grouping clients and creating portfolios; rather it should be used as a tool to start a deeper conversation between clients and advisers.
Do you need to review your Risk Profile?
If you need assistance, you should speak with your Patersons Wealth Adviser, who can assist with updating your appropriate Risk Profile.
Your adviser can also discuss a regular portfolio review process with you, if you do not already have one in place.
It is also important that, should your personal or financial circumstances change, you inform your adviser and discuss whether your current risk profile is appropriate.
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.