European Portfolio Advisory Group European investor insights survey
Investor Risk Profiles and Portfolio Strategy
Transcript of Investor Risk Profiles and Portfolio Strategy
11 May 2020
Investor Risk Profiles and Portfolio StrategyBob Dannhauser, CFA, FRM, CAIA
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SEBI requirements
✤ Investment adviser shall ensure that:
✤ (a) it obtains from the client, such information as is necessary for the purpose of giving investment advice, including
the following:
✤ (i) age
✤ (ii) investment objectives including time for which they wish to stay invested, the purposes of the investment
✤ (iii) income details
✤ (iv) existing investments/assets
✤ (v) risk appetite/tolerance
✤ (vi) liability/borrowing details
Source: SEBI (Investment Advisers) Regulations 2013 https://www.sebi.gov.in/legal/regulations/jan-2013/sebi-investment-advisers-regulations-2013-last-
amended-on-december-08-2016-_34619.html3
SEBI requirements
✤ (b) it has a process for assessing the risk a client is willing and able to take, including:
✤ (i) assessing a client’s capacity for absorbing loss;
✤ (ii) identifying whether client is unwilling or unable to accept the risk of loss of capital;
✤ (iii) appropriately interpreting client responses to questions and not attributing
inappropriate weight to certain answers;
✤ (c) where tools are used for risk profiling, it should be ensured that the tools are fit for
the purpose and any limitations are identified and mitigated
Source: SEBI (Investment Advisers) Regulations 2013 https://www.sebi.gov.in/legal/regulations/jan-2013/sebi-investment-advisers-regulations-2013-last-
amended-on-december-08-2016-_34619.html4
SEBI requirements
✤ (d) any questions or description in any questionnaires used to establish the risk a client
is willing and able to take are fair, clear, and not misleading, and should ensure that:
✤ (i) questionnaire is not vague or use double negatives or in a complex language that
the client may not understand;
✤ (ii) questionnaire is not structured in a way that it contains leading questions
✤ (e) risk profile is communicated to the client after risk assessment is done
✤ (f) information provided by clients and their risk assessment is updated periodically
Source: SEBI (Investment Advisers) Regulations 2013 https://www.sebi.gov.in/legal/regulations/jan-2013/sebi-investment-advisers-regulations-2013-last-
amended-on-december-08-2016-_34619.html5
“People are ‘rational’ in standard finance; they are ‘normal’ in behavioral finance.
Rational people care about utilitarian characteristics but not value-expressive
ones, are never confused by cognitive errors, have perfect self-control, are always
averse to risk, and are never averse to regret. Normal people do not obediently
follow that pattern.”
–Meir Statman (1999)
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What do advisors actually do?
Professional Judgment
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What do advisors actually do?
“A global study of over 200 professional financial advisors is undertaken to
test how risk profile factors are used to make investment portfolio allocation
recommendations. When presented with identical risk profile information,
similar to what a competent financial advisor would normally collect from a
prospective client, respondents are asked to recommend a portfolio allocation
among equity, fixed income, and cash for five hypothetical client scenarios.
The results find that financial advisors, using their professional
judgment, inconsistently puzzled together the presented risk profile
factors into portfolio recommendations, on average doing little more than
applying the heuristic 100-minus-age rule to recommendations…”
8Amy Hubble, John E. Grable. “The Efficient Frontuzzle: What Investment Risk Profiling Still Fails To Solve
The Journal of Investing Sep 2019, 28 (6) 73-90; DOI: 10.3905/joi.2019.1.098
What should advisors do?
✤ Measure and reconcile three dimensions of investment risk profile
1. Risk Need
2. Risk-taking Ability
3. Behavioral Loss Tolerance
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Behavioral Loss Tolerance
1. Risk tolerance
2. Risk preference
3. Financial knowledge
4. Investing experience
5. Risk perception
6. Risk composure10
Assessing Validity and Reliability
✤ Validity - how accurate the tool is in describing or predicting attitudes or
behavior
✤ Content validity
✤ Criterion validity (concurrent and predictive)
✤ Reliability - how well the test generates the same results when the same
person takes it in the same setting
✤ Cronbach’s alpha (> 0.70) common but subject to some criticism11
Red flags in assessment instruments
✤ Questions outside the context of investment risk taking
✤ Questions make investors anticipate their future behavior
✤ Questions pose 50/50 chance outcomes
✤ Questions are leading
✤ Questions use complex language (or are written for CFA charterholders!)
✤ Questions are too ambitious/doublebarreled
✤ Too few questions
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What should advisors do?
✤ Three dimensions of investment risk profile: measure and reconcile
1. Risk Need
2. Risk-taking Ability
3. Behavioral Loss Tolerance
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Assessing Risk-taking Ability
✤ Goal time horizons
✤ Need for liquidity
✤ Risk capacity
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What should advisors do?
✤ Three dimensions of investment risk profile: measure and reconcile
1. Risk Need
2. Risk-taking Ability
3. Behavioral Loss Tolerance
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Establishing Investor’s Risk Need
✤ Determine required rate of return for achievement of goals
✤ Relate current assets and PV of cash flows to PV of liabilities (goals)
✤ Consider market risk environment (i.e. is the required rate of return
realistic?)
✤ Consider consequence of failure to achieve goal
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Reconciling the 3 dimensions to create Portfolio
Strategy
✤ Risk need can’t exceed risk-taking ability for a goal
✤ Lower risk need can be discounted when ability and tolerance are high
✤ High tolerance can be discounted when need and ability are low
✤ Low tolerance can’t be ignored - but might be coachable if need and ability are
high
✤ Risk-taking ability is an upper bound on portfolio volatility - but it changes over
time and needs reassessment17
Reflecting the Risk Profile Discovery process in
the IPS
✤ The Investment Policy Statement (IPS) is a useful place to memorialize key
dimensions of the investor risk profile that informs your portfolio strategy
✤ Document the objective dimensions (risk need, risk-taking ability)
✤ Acknowledge/Characterize behavioral loss tolerance
✤ The “Achievement Policy Statement” can document decumulation planning
and reflect the investor risk profile, especially risk-taking ability
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Client Risk Profiling Shouldn’t Be A Black Box
✤ Thoughtful compliance that actually improves the end product
✤ “Rehearse Disaster” in client communications and reviews
✤ Differentiate the value of your professional judgment
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Read More About It
✤ CFA Institute: “Investment Risk Profiling: A Guide For Financial Advisors”
https://www.cfainstitute.org/-/media/documents/survey/investment-risk-
profiling.ashx or Google “CFA Risk Profiling Dannhauser”
✤ The Journal Of Investing: “The Efficient Frontuzzle: What Investment Risk
Profiling Still Fails To Solve. https://joi.pm-
research.com/content/early/2019/07/27/joi.2019.1.098
Thanks for your attention and attendance! [email protected] @robdnn
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