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Defaqto: Risk tools – are they all that?

Technology update for Financial Advisers and Paraplanners

5 Feb 2019

Defaqto: Risk tools – are they all that?

There is an unprecedented amount of column inches being written about matching a clients’ attitude to risk and capacity for loss to an appropriate investment risk rating. The more that is written, the easier it is to forget what you are trying to achieve in the first place and there seems to be plenty of negative opinion on just about every solution.

This article was originally published in Multi-Asset Review.

Fraser Donaldson, Insight Consultant (Funds & DFM)

So, back to basics. There are two sides to the equation. Firstly, and most importantly, the client. There are essentially two types of client. There are those that understand and are prepared to take some risk in return for potential reward and there are those that are not prepared to take any risk with their hard earned savings.

I don’t think you need any type of tool to identify the latter category, although discussions around goals and future anticipated lifestyle may lead a client to conclude that taking a little risk could be necessary.

There are any number of tools out there that will help identify the natural risk profile of a client. Once real world capacity for loss and anticipated timescales are taken in to account the client will probably have a risk number attributed to them that falls on a scale between minimal risk and ‘gambler’. This equates to a level of investment risk they would not be comfortable exceeding.

Using the relevant tools 

I am not going to critique the tools used to establish a client’s risk profile as the regulators have issued plenty of guidance on this and continue to do so. However, I would suggest that there does need to be some science or logic behind them and the advisers who use them do need to understand them and more importantly, be confident in their use.

As the outcomes of these tools are often the starting point for identifying suitable investments, which more often than not have been risk rated, it is important that the fundamental methodology of the client risk profiler is compatible with the methodology for risk rating the investment solutions.

A little note of warning for the client side of the equation. The questions asked in establishing the clients risk profile are likely to be geared towards wealth accumulation. You should be asking a different set of questions for clients whose priority is income. As an example, a client who can accept a certain amount of volatility in their capital value as they are accumulating wealth, may only be willing or able to accept minimum volatility in their income.

Right, let us hop to the other side of the equation. The question that many of us are trying to answer, and provide a solution to, is: ‘If the client has a ‘risk number’ created by a risk profiling tool, what is the best way of using this information to establish a suitable investment for the client?’

The safest way is to use an end to end solution that uses the same science and methodology for rating the client as is used for rating the investment solution. If this is not the case, the tools used on either side of the equation do need to be compatible. This may mean mapping risk tools to each other where possible, bearing in mind different scales of ratings, different time periods, different measures of volatility and historic volatility vs predicted future volatility.

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