investor risk profiling
TRANSCRIPT
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For investment proessionals only not or retail investors. The value o
investments, and the income rom them, may all or rise and investors may get
back less than they invested.
Investment risk and inancial advice
A guide to using Vanguards risk proling tool as a startingpoint to discovering a clients true risk prole.
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Contents
4 What is risk?
8 Adviser as alpha
12 The FSA and proling client risk
14 Clients true risk prole and asset allocation18 Starting conversations by measuring willingness
22 Behavioural aspects o risk attitude
31 Reerences and urther reading
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What is risk?
Your clients perception o risk and what the investment industry
portrays as risk can dier radically. This can lead to challenges or
advisers i they rely solely on quantitative measures o risk, such as
volatility or example.
Experience in markets where ee-based advice models are well
established, suggests that advisers should consider taking a more
comprehensive approach to educating their clients about the nature
o investment risk, as well as understanding their clients true and
complete risk prole.
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5What is risk?
Risk is not a single number
Technically-speaking, risk means the
possibility o a number o dierentoutcomes resulting rom a given action.
For example, beore you fip the coin you
know the result could be heads, tails or land
on its edge. Ater you toss the coin, one
o the three outcomes will occur.
Investment academics usually identiy risk
as the volatility associated with the prices
and/or returns o investments. However, we
believe this approach is much too narrow
or nancial advisers to use in their practice.
This is because clients do not think in terms
o narrow mathematical terms. Indeed,
clients oten think o risk as the prospect o
an undesirable outcome, such as a nancial
loss or not meeting an investment objective.
Risks your clients ace
Ination
Infation is like a stealth tax eating away atthe value o money. Clients may not see
a smaller cash balance in their accounts,
but they will denitely lose buying power.
In other words, the amount that they can
purchase with each pound in their pockets
slowly erodes over time.
Investors need to understand that some
savings vehicles ail to pay a return that
beats infation, especially ater tax is
deducted. So even i they reinvest every
penny o interest, the real purchasing power
o their savings could all.
Shortall
This means the risk o ailing to meet a long-
term investment goal. This could occur i an
investor didnt take on enough risk to get
the potentially higher rewards. On the other
hand, they could also be exposed to shortall
risk i they invest in too many high-risk
assets causing their portolio to lose value at
the wrong time.
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What is risk?6
A key eature o these risks is the apparent
inability o even the most skilled economists
and political scientists to predict them. You,
as the adviser, have a key role in explainingthat these risks are unpredictable and in
structuring portolios in such a way as to help
manage the impact these risks can have.
Broad market
Individual markets, whether equities, bonds
or even cash, are exposed to a variety o
actors that can lead whole markets, or even
most markets, to decline together. We have
seen this over the last decade, most markedly
during the recent global nancial crisis.
The relationship between risks and rewards
needs careul explanation to ensure that
investors understand how you are
structuring their portolios through time.The myriad o risks that can aect a clients
investment portolio can be daunting. But
shortall risk together with infation risk
highlight the need to invest to meet
long-term goals.
Economic/political
Economic and political actors play an
important role in the perormance o
investment markets. Economic actors
include economic growth, infation,
employment, interest rates and business
sentiment. Political risk includes changes
in government, political uncertainty and
international conficts.
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7What is risk?
Asset-based risks
There are also a number o potential risks associated with individual assets or asset classes
that investors need to consider.
Country The risk that domestic events such as political upheaval, nancial troubles, or natural
disasters will weaken a countrys nancial markets.
Credit The possibility that a bond issuer will ail to repay interest and capital on time. Funds that
invest in bonds are exposed to credit risk.
Currency The risk that changes in currency exchange rates cause the value o an investment to decline.
Interest The possibility that the prices o bonds will all i interest rates rise.
Liquidity The chance that an investment will be dicult to buy or sell.
Manager The chance that an investment will underperorm due to poor investment decisions by the
investment manager.
Sector The risk that a particular sector within a market, such as the oil and gas sector, or the travel
sector, may decline in value. For example, i oil prices surge, the oil and gas sector might rise,
but the travel sector might all due to rising uel costs.
Volatility Dierent types o investments fuctuate in value over time. This is reerred to as volatility
and is oten used by the investment industry to assess the potential risk associated with
an investment.
Security The risk that a specic share, bond or und youve invested in perorms badly.
Risk and your service promise
Explaining the various risks to clients helps
them to gain a better understanding o
the risk they take by investing. For the
adviser, it can also help detach the servicepromise they make to their client rom
the actual perormance o the investments
they recommend. Ater all, advisers do
not have any control over the perormance
o markets and making perormance
promises, actual or implicit, runs the risk o
leading to disappointment or the client and
disaection with the adviser.
See the next section or a uller description
o this process.
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Adviser as alpha
The data shows that picking investments that consistently outperorm
the broad market has historically been very dicult. This can lead to
disaection on the part o clients when investment results are not what
they eel they have been promised, even i you didnt explicitly promise
them anything.
The experience o successul ee-based advice practices in the UK
and abroad suggests advisers may be better served by changing their
perormance benchmark rom the markets return to the returns that
investors might achieve without your help.
A nancial adviser has a greater probability o adding value, i.e. alpha,
through relationship-oriented services, such as providing wealth
management, nancial planning and acting as their clients behavioural
coach, than by attempting to outperorm the market.
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9Adviser as alpha
Financial advice and RDR
With the end o commission, the nancial
advice market will complete its ongoingshit rom transaction-oriented sales to ee-
based advice.
From the clients perspective, ee-based
advice largely removes concerns about
potential conficts o interest in an advisers
recommendations. From the advisers
perspective, ee-based compensation can
promote stronger client relationships and
more reliable income streams. The adviser
can spend more time with clients, knowing
that compensation does not depend on
whether or not a transaction occurs.
What do we mean by the adviser
as alpha?
For some clients, paying ees whether ornot a transaction occurs may seem like
money or nothing. The conusion can grow
i the adviser bases their value proposition
on an ability to deliver better returns or
the client. But better returns relative to
what? For many advisers and clients, the
answer would be better than the market.
However, a more pragmatic answer or
both parties might be better than investors
would likely do i they didnt work with a
proessional adviser.
In this ramework, advisers demonstrate
their alpha by their ability to eectively act
as a wealth manager, nancial planner and
behavioural coach providing discipline and
logic to clients who are oten undisciplined
and emotional than by eorts to beat
the market.
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Adviser as alpha10
Historical studies o mutual und cash
fows show that ater protracted periods
o relative outperormance in one area o
the market, sizeable cash fows tend toollow. This perormance-chasing behaviour
can seriously harm a clients long-term
returns. The adviser as alpha target, then,
might be to improve upon this return
shortall by means that dont depend on
market outperormance: asset allocation,
rebalancing, tax-ecient investment
strategies and cash-fow management. It
can also mean, where appropriate, coaching
clients to change nothing at all i the clients
asset allocation model remains in line with
their risk prole and investment goals.
Proessional stewardship and
investor behaviour
Rather than investment capabilities,the adviser as alpha model relies on the
experience and stewardship that the adviser
can provide. Let alone, investors oten
make choices that impair their returns and
jeopardise their ability to und their long-
term objectives. Many are infuenced by
market perormance. This is oten evident in
market cash fows mirroring what appears
to be an emotional response ear or greed
rather than a rational one. Investors also
can be moved to act by und advertisements
that eature recent outperormance as i
the investor could somehow inherit those
historical returns despite disclaimers stating
that past perormance is no guarantee o
uture returns.
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11Adviser as alpha
For an insight into destructive investment
behaviour, with practical guidance on how
advisers can act as a behavioural coach,
please see our guide: Behavioural fnance
Behavioural inance
Understanding how the mind can help
or hinder investment success
By AlistairByrne
With Stephen P Utkus
For investment proessionals only not or retail investors.
To gain some insight into how to dene
a compelling client promise one that
is not tied to investment perormance
and that clients explicitly understand and
are willing to pay you to keep see our
guide Making a compelling client promise.
For investment proessionals only not or retail investors.
Deining a compelling client promise
Building a successul ee-based advice practice
The Financial Services Authority
guidance
But just as risk is not a single number, sotoo is a clients risk prole not a single
number or psychological dimension that can
be easily measured. The FSA recognised
this and issued new guidance on assessing
client suitability. The next section explores
the FSAs guidance on assessing investment
suitability.
For more inormation on building a robust
and systematic investment advice process,
please see our guide: Building a robust
investment advice process.
For investment proessionals only not or retail investors.
Building a robust investment advice process
Create business value Manage regulatory risk Delight your clients
For investment proessionals only not or retail investors.
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The FSA and proling
client risk
The FSA has studied the way client risk tolerance has traditionally beenproled by the industry and ound it wanting. As a result, it issued new
guidance consultation in January 2011: Assessing suitability: Establishing
the risk a customer is willing and able to take and making a suitable
investment selection. Any consideration o risk or risk proling must
take careul account o the FSAs ndings and guidance. The guidance
provides sobering reading or any adviser that has come to rely on
single-dimension measurements o risk proles.
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13The FSA and proling client risk
The consultation key ndings
The ollowing summary should not be considered as a substitute or reading the ull guidance
paper which can be ound on the FSA website.
Failure to collect and
properly account or all
the inormation relevant
to assessing the risk a
customer is willing and
able to take
Many rms ail to take account o a clients capacity or loss.
Many risk questionnaires rely on poor questions, scoring and
interpretations.
Failure to identiy customers that are unwilling to accept any risk o capital.
Relying on risk-profling
and asset-allocation tools
Failure to identiy limitations and faws in tools.
Need to mitigate limitations through suitability assessments and ull know
your customer processes.
Poor descriptions oattitudes to risk
Many descriptions not t or purpose.
Overly vague.
Do not eectively explain or dierentiate risk levels.
Failure to select suitable
investments or the
customer
Failure to match asset allocation and/or investments to a correctly
assessed client risk prole.
Failure to take account o all aspects o a clients objectives and nancial
situation.
Inappropriate ocus on the
risk a customer is willing
to take
Failure to take account o client needs, objectives and circumstances
outside o willingness.
Failure to recognise that suitability is about more than a clients attitude
to risk.
Understanding products
and underlying assets
Failure to understand the nature o the risks associated with assets
selected or clients.
Responsibilities when
using tools
Suggestion that rms do not appear to understand the tools they use.
Firms remain responsible or assessing suitability, even when using tools.
Tool providers need to provide clear supporting inormation to rms that
will use the tools to help rms use them as designed.
The FSAs timely ndings and guidance has inormed every step o the development o our
tool or measuring investor risk proles and the process we advocate or using it. Wevewritten this guide, in part, to help advisers address the FSAs concerns.
You will also nd some helpul checklists and tools at the end o this guide, designed to help
you structure your approach to applying the regulators guidance in your business.
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Clients true risk prole
and asset allocation
In the past, some advisers might have stopped with a clientswillingness to take risk as measured by an attitude to risk tool, and
proceeded directly to selecting investments. However, in light o RDR
and increasing regulator scrutiny, the results o such a tool should only
provide a starting pointor a conversation about investment risk, not
an ending. It should not be thought o as a substitute or a suitability test
But what is the most appropriate way to develop a clients risk prole,especially in light o the FSA guidance?
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15Clients true risk prole and asset allocation
Starting conversations
Asking your client to complete a risk proling
questionnaire should mark the beginning oa conversation with them about risk. You
can use the generalised output to move the
conversation onto deep and critical issues
in the know your client process. Only by
having a thorough and careully structured
conversation, as part o a systematic
approach to investment advice, can advisers
understand a given clients true investment
risk prole.
Our experience in other ee-based advice
markets suggests that this is where advisers
can add real value or clients.
Willingness is just the beginning
A clients willingness to take risk, as
measured by a questionnaire or example,is only a small part o a clients ull and true
risk prole.
Willingness Ability
Need
Trueclient risk
prole
Three key components comprise an
individuals true risk prole:
Psychological willingness to take risk,
sometimes called risk attitude
Financial ability to take risk, or risk
capacity
Need to take risk, including the need to
accept risk to meet an objective, avoid
alling short o a goal or having wealth
eroded by infation.
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Clients true risk prole and asset allocation16
Contradictions in the risk prole
Clients psychological willingness to take
risk can sometimes clash with their nancialability to do so. For example, i someone
has a high risk tolerance, but has a nely
balanced nancial situation. When such a
confict exists, nancial advisers need to
take time to counsel the client and explain
the consequences o the mismatch. Youll
need to explain the consequences o low
or negative returns to more aggressive
investors with less liquid wealth.
Ultimately, a client might insist on an
investment strategy that matches their risk
attitude and the adviser may need to accept
this. But having had the conversation, the
client/adviser decision will at least be in
the context o a thorough review o the
investors risk capacity, attitude and need.
Ability to take risk relates to nancial
circumstances and investment goals.
Generally speaking, the higher the level o
wealth relative to liabilities, and the longerthe investment horizon, then the greater the
ability to take risk. The nancial planning
process should consider all o these issues
careully.
Willingness, or risk attitude, on the other
hand, relates to psychology, rather than to
nancial circumstances. Some individuals
nd the prospect o investment volatility and
the chance o losses distressing. Others are
more relaxed about those issues. Financial
advisers should try to ully understand the
psychological willingness o each client
to take risk. This is what risk proling
questionnaires ocus on.
The need to take risk is the third component
o a true client risk profe. Willingness and
ability need to be evaluated in the context o
an individuals need to take risk to achieve a
goal. I they have a very low risk prole with
a very demanding investment objective,
something will have to give.
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17Clients true risk prole and asset allocation
The investment objectives and the
client risk prole
People can sometimes have dierent riskproles with dierent pools o assets. They
might be willing to take on considerable risk
with assets they earmark or a particular
goal, but not with others. The simplest
way to think o this is to think o the 5
some people spend each week on lottery
tickets. Theyre willing to take the highest
risk possible with that 5, but not with the
money they set aside or their childrens
education.
While this kind o separation might not make
sense rom a purely nancial theory point
o view, many investors rely on separate
mental accounts when thinking about
their investments. For more inormation on
mental accounting please see our guide:
Behavioural Finance Understanding how
the mind can help or hinder investment
success.
Dierent risk proles in couples
Sometimes couples that deal with their
investments together have conficting riskattitudes. In this case, youll need to explain
the consequences o dierent strategies and
approaches. It may be possible to negotiate
a compromise position ater explaining the
issues, but in some cases the views o one
spouse will prevail.
Later in this guide youll nd a section on
having this conversation with your clients,
including a helpul checklist and other
practical tools.
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Starting conversations by
measuring willingness
Having established that a clients willingness to take risk is just thebeginning o a client conversation about risk, we can ocus on how to
best measure that willingness.
You can measure risk attitude in a variety o ways, each with its
own advantages and disadvantages. Best practice suggests using a
structured interview or a questionnaire to help draw out the issues.
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19Starting conversations by measuring willingness
Measuring willingness the
Vanguard approach
Risk attitude is a complex area and as aresult risk proling is not an exact science.
Nonetheless, a well-designed risk proling
tool can still make an important contribution
to the nancial planning process.
Vanguards online risk attitude proling tool
or UK advisers is based on the Byrne-Blake
Attitude to Risk Questionnaire. The Byrne-
Blake approach to risk proling builds on
established psychometric principles and
represents best practice rom the science
o measuring an individuals willingness to
take risk.
The questionnaire has been designed or
ease o use by a variety o dierent client
types. It avoids questions that present
complex investment scenarios, require
mathematical calculations or use concepts
such as percentages. We also sought to
avoid vague questions, or those that deal
with issues that people outside the industry
might not know anything about.
How the tool works
The tool uses a series o short statements
ollowed by a scale where the individualcan indicate whether they agree or not with
a statement. The scale, known as a Likert
Scale, typically includes:
Strongly Agree
Agree
No Strong Opinion
Disagree
Strongly Disagree
The questionnaire has 12 questions, making
it relatively ast and easy to complete. It
typically takes less than six minutes. The
tool uses a ve-point scale as more choices
could make the questions too complicated.
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Starting conversations by measuring willingness20
Questions with any o the ollowing
characteristics were culled rom the
question bank.
Questions the test group ound dicultor irrelevant.
Questions that ailed to accurately predict
a given characteristic or dierentiate
among individuals (See or example,
Grable and Lytton, 2003).
Statistically outlier questions that
werent closely correlated (less than 0.30)
compared to the overall index score.
Normalising the questions
The nal questionnaire needed to be long
enough to produce reliable results, while
short enough to be used in the nancial
planning process. A baseline or norm was
then established or the questionnaire in
order to map respondents to broad risk
categories.
To establish a norm group or the
short questionnaire, Byrne and Blake
commissioned market research rm YouGov
to conduct an online survey with a sample
representative o the British population. The
results o this study allowed a comparison o
each individuals response to the distributiono responses across the population. This
allowed the testing o the reliability o a
questionnaire using the pilot study.
Writing the questions
Byrne and Blake identied the various
components that make up an individualsrisk attitude and wrote questions to address
each component. Following best practice,
each question contains only one question or
statement and avoids subjective words like
requency whenever possible.
Testing the questions or
suitability
All o the questions have passed suitability
screening by a test group. 141 individuals
completed the initial online test.
The initial test group had the ollowing
characteristics:
65% male; 35% emale
Average age o 35 years
Ages ranged rom 19 to 70 years, with a
standard deviation o 11 years
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21Starting conversations by measuring willingness
Answers to questions are scored rom
0-4, depending on whether the question
uses standard or reverse wording. This
means that the raw scores or the shortquestionnaire range rom 0 to 48.
When reporting the test scores, the scores
were normalised by subtracting the mean
score and dividing by the standard deviation.
In order to improve the clarity o the score,
the reported scores were urther adjusted
so that an average response gets a score o
50 and the distribution o reported scores
has a standard deviation o 10. This ts more
readily with peoples perceptions o where
their score should all on a scale o 0-100.
The adjusted scores are then used to map
individuals to broad risk attitude categories
(see the ollowing section or descriptions o
these categories).
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Behavioural aspects o
risk attitude
The complexities o measuring investment risk attitude require that thequestionnaire address a number o interrelated actors. Vanguards tool
addresses our identied behavioural actors o risk.
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23Behavioural aspects o risk attitude
Knowledge
Individuals with more nancial and
investment knowledge are generallymore willing to accept investment risk.
Knowledgeable individuals oten know
that they will need to take at least some
risk to generate higher returns. Short-term
fuctuations in the values o investments
need not matter or investors with longer-
term horizons.
Comort with risk
Some individuals have psychological traits
that allow them to accept taking risk. These
individuals typically see risk as involving
a thrill or opportunity rather than as a
danger or a loss. Questions addressing
risk comort levels oten involve individuals
choosing among alternative courses o
action relating to saving decisions, or simply
stating their comort level with risk.
Investment choice
Preerences or dierent kinds o
investments can also help to gauge risk
attitude, or example, the saety o a bank
account versus the risk/return potential othe stockmarket. However, questions o this
nature need to avoid using nancial jargon
to ensure that clients truly understand the
questions asked.
Regret
This negative emotion arises rom making
the wrong decision. Individuals who areparticularly prone to regret tend to try to
make decisions that are less likely to cause
it. For example, they might engage in regret
avoidance.
The allocation o questions across the
various categories:
Risk attitude aspect Number o questionsin questionnaire
Knowledge 2
Comort with risk 3
Investment choice 6
Regret 1
Total 12
For a straightorward guide to some
behavioural traits related to investing
and risk, along with the consequences
or advisers, see our guide: Behavioural
nance Understanding how the mind
can help or hinder investment success. Itsavailable ree or proessional investors on
the Financial adviser section o our website
Vanguard.co.uk.
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Behavioural aspects o risk attitude24
Pre-screening: short, medium and
long term
The length o an investment time horizoncan change the types o investments an
adviser should consider or a given client.
For that reason, our tool takes this into
account when scoring the questionnaire, or
deciding i investing bonds and/or equities is
even appropriate.
Our questionnaire then asks: How long do
you intend to invest beore you need your
money?
I a respondent answers less than three
years to this question, the tool stops
there, deaulting to what is, in eect, a
savings only position.
I a respondent answers between three
and ten years, the tool deaults to a
medium term (3-10 years) algorithm to
score the questionnaire
I a respondent answers more than
ten years, the tool deaults to a long
term (10+ years) algorithm to score the
questionnaire.
The tool includes a variety o underlying
algorithms and calculations to arrive at a
generalised risk category with which to
start a client conversation. Beore movingon to the twelve questions that comprise
the questionnaire, the tool pre-screens
respondents to nd out i they should even
be considering investing at all, based on a
no risk attitude, or too short a time horizon.
Pre-screening: saving vs. investing
Vanguard believes that anyone who is
unwilling to take any risk with their capital
should not consider investing in anything
other than the saest savings vehicles. For
that reason, our questionnaire asks:
Are you prepared to take the chance
o losing some o your investment in
seeking income or growth rom your
investment portolio?
I a respondent answers No to this
question, the tool stops there, deaulting to
what is, in eect, a savings only position.
Advisers would need to make them aware
o the ull ramications o their cautious
attitude, in terms o the long-term value o
their savings vs. the eect o infation.
Scoring the questionnaire
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25Behavioural aspects o risk attitude
Risk proling questions
People who know me would describe me
as a cautious person. I eel comortable about investing in the
stock market.
I generally look or the saest type o
investment, even i that means lower
returns.
Usually it takes me a long time to make up
my mind on nancial matters.
I associate the word risk with the idea o
opportunity.
I preer the saety o keeping my money in
the bank.
I nd investment and other nancial
matters easy to understand.
I am willing to take substantial nancial
risk to earn substantial returns.
I have little experience o investing in
stocks and shares.
When it comes to investing, Id rather be
sae than sorry.
Id rather take my chances with high risk
/ high return investments than have to
increase the amount I am saving.
I am concerned by the uncertainty o
stock market investment.
Twelve risk prole questions
Each question uses a ve-point scale
ranging rom Strongly Agree through toStrongly Disagree.
The questionnaire includes a blend o
normal questions, where agreement
indicates an inclination to take risk and
reverse questions where agreement
indicates aversion to risk. The proling
tool compiles the score by weighting the
answers equally, taking account o whether
they are normal or reverse questions.
Question
response
Score or
normal
questions
Score or
reverse
questions
Strongly agree 4 0
Agree 3 1
No strong opinion 2 2
Disagree 1 3
Strongly disagree 0 4
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Behavioural aspects o risk attitude26
Sense checks
The scoring o the tool also includes
sense checks along the way to account orcontradictions in a respondents answers.
For example, someone may answer nearly
all o the questions in such a way that
indicates high comort with risk taking
such that the tool puts them into the high
category. However, theyve indicated that
they strongly disagree with the statement:
I eel comortable about investing in the
stock market. The output would highlight
this apparent contradiction so their nancial
adviser could delve urther into the topic
with them as part o the conversation that
could lead to a ull understanding o their
true risk prole.
Generating output
Based on time horizon indicated in the
second question, and the Byrne-Blakeproprietary algorithm, the score will be
calculated to output a generalised risk prole
broken into ve labels. See descriptions on
ollowing page
Low
Low mid
Mid
Mid high
High
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27Behavioural aspects o risk attitude
Low-mid risk investors with time horizons o
ten or more years typically have portolios
with a majority o bonds and cash, but with
some exposure to equities and other higherrisk investments.
Mid risk
In general, mid risk investors understand
that they have to take investment risk to
meet their long-term goals. Theyre oten
more willing to take risk with at least part
o their available assets. Mid-risk investors
may have some experience o investment,
including investing in products containing
higher risk assets such as equities and
bonds. They can usually make up their
minds on nancial matters relatively quickly,
but they still suer rom some eelings o
regret when their decisions turn out badly.
Mid risk investors with time horizons o ten
years or more typically have portolios with
a mix o higher risk investments such as
equities and lower risk investments such as
bonds and cash.
Low risk
In general, low risk investors preer knowing
that their capital is sae and theyre notcomortable investing in equities. They
would rather keep their money in the bank.
Low risk investors are unlikely to have
much experience o investment beyond
bank accounts. They will usually suer rom
severe regret i their decisions turn out badly.
Low risk investors with time horizons o
ten years or more typically have portolios
with a majority o bonds and cash, with
little exposure to equities or other higher
risk investments. Low risk investors need
to understand that their caution can mean
that their investments may not keep pace
with infation, or that may all short o their
investment goal.
Low-mid riskIn general, low-mid risk investors would
preer not to take risk with their investments,
but they can be persuaded to do so to a
limited extent. They would preer to keep
their money in the bank, but they may realise
that other investments might be better over
longer term. Low-mid risk investors may
have some limited experience o investmentproducts, but will be more amiliar with bank
accounts than other types o investments.
Low-mid risk investors can oten suer regret
when decisions turn out badly.
Description o investor risk appetites
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Behavioural aspects o risk attitude28
High Risk
In general, high risk investors want the
highest possible return on their capital andare willing to take considerable amounts o
risk to achieve this. Theyre usually willing
to take risk with all o their available assets.
High risk investors typically have substantial
amounts o investment experience and will
typically have been managing their own
investments. High risk investors have rm
investment views and will make up their
minds on nancial matters quickly. They do
not suer rom regret to any great extent
and can accept occasional poor outcomes
without much diculty. High risk investors
with time horizons o ten years or more
typically have portolios made up primarily
o higher risk investments such as equities,
with little in bonds and cash.
Mid-high Risk
In general, mid-high risk investors are willing
to take on investment risk and understandthe nature o the long-term risk/return trade
o. Theyre willing to take risk with most o
their available assets. Mid-high risk investors
are typically experienced investors, who
have used a range o investment products in
the past. Mid-high risk investors will usually
be able to make up their minds on nancial
matters quite quickly. While they can suer
rom regret when their decisions turn out
badly, they can accept that occasional poor
outcomes are a necessary part o long-term
investment. Mid-high risk investors with
time horizons o ten years or more typically
have portolios with a majority o higher risk
investments such as equities, but that also
contain bonds and cash.
Note: These profle descriptions are only illustrative. While they outline
the common traits o individuals with the relevant risk profle scores, every
individual is dierent and their scores will be built up rom dierent
combinations o responses to the questions in the risk attitude profling
questionnaire. The results should support and enhance, not replace, the knowyour client process. Financial advisers should use this to start a discussion
about investment risk with the investor.
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29Behavioural aspects o risk attitude
Checklist: Using third-party risk
proling tools
Again, with the FSA guidance in mind, yourrisk proling tool should:
Support regulation and refect FSA
guidance
Describe its scope and any limitations
Explain its provenance and structure
Identiy clients with no-risk proles
Be written in client riendly language
Include an audit trail acility
Be simple and easy to use
Checklist: Selecting investments
Implement a robust investment process
Research on investment undamentals
Match appropriate product to risk
willingness, ability and need
Measure risk using more than just
volatility
Consider graded unds to cover risk range
Ensure unds have clear and descriptive
(not potentially misleading, e.g. cautious)
names
Look or complete transparency o und
components
We have created a number o tools and
checklists to help you assess risk with your
clients, understand their true risk prole
and help you to comply with the FSArequirements.
Checklist: Establishing a clients
willingness or risk
Based on the FSA guidance, the process
used to establish a clients willingness to take
risk should:
Help you to ully understand the clients
capacity or loss
Help you ully understand their capacity
or risk
Include clear and understandable questions
Highlight conficting responses
Use dierentiated and well described
risk categories
Include supporting charts o the variance
o possibilities
Have the ability to record alternative advice
Tools and checklists
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Behavioural aspects o risk attitude30
We have also created a guide designed to
help you discuss investment risk with your
clients. It discusses investment risk and
potential reward in a short, straightorwardand client-riendly manner. You can
download the guide rom our website, or
order printed copies rom Adviser Support.
Client tools
Visit the Practice management section
o our Adviser website or a series oworksheets to use with your clients,
including:
Financial satisaction survey
Lie goals prole
Lie transitions prole
Simplied personal balance sheet
Simplied personal cash fow statement
Financial lie history
Lie principles
Guidance or how to use these sheets can
be ound in our extensive guide Building
a robust investment advice process.
For investment proessionals only not or retail investors.
Building a robust investment advice process
Create business value Manage regulatory risk Delight your clients
For investment proessionals only not or retail investors.
Investment risk
Balancing investment risk and potential reward
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31Reerences and urther reading
Cordell D. (2002) Risk tolerance in two
dimensions Journal o Financial Planning,
May 2002.
Grable J. and Joo S. (2000) A cross-
disciplinary examination o nancial risk
tolerance Consumer Interests Annual46.
Grable J. and Lytton R. (1999) Financial
risk tolerance revisited: the development
o a risk assessment instrument Financial
Services Review8, 163-181.
Hanna S., Gutter M. and Fan J. (2001)
A measure o risk tolerance based on
economic theory Financial Counselling and
Planning, 12:2, 53-60.
Kline P. (1993) The Handbook o
Psychological TestingLondon: Routledge.
Loomes G. and Sugden R. (1982) Regret
theory: an alternative theory o decision
under uncertainty Economic Journal92,
805-824.
Maginn J., Tuttle D., McLeavey D., Pinto J.
(2005) The portolio management process
and the investment policy statement in
Managing Investment Portolios: A DynamicProcessedited by J. Maginn and D. Tuttle.
Charlottesville VA: CFA Institute.
For a good overview o nancial risk
tolerance, risk attitude and risk proling, we
recommend starting with Grable and Lytton
(1999) and Roszkowski et al. (2005).
For an in-depth description o psychometric
analysis and test design, we recommend
Kline (1993) and Rust and Golombok (1989).
See below or ull reerences
Reerences cited:
Bailey J. and Kinerson C. (2005) Regret
avoidance and risk tolerance Financial
Counselling and Planning16:1, 23-28.
Barber B. and Odean T. (1999) The courage
o misguided convictions: The trading
behaviour o individual investors Financial
Analysts Journal, November.
Callan V. and Johnson M. (2002) Some
guidelines or nancial planners on
measuring and advising clients about their
levels o risk tolerance Journal o Personal
Finance1:1, 31-44.
Carducci B. and Wong A. (1998) Type A
and risk taking in everyday money matters.Journal o Business and Psychology, 12,
355-359.
Reerences and urther reading
Reerences and urther
reading
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32 Reerences and urther reading
Roszkowski M., Davey G. and Grable J.
(2005) Insights rom psychology and
psychometrics on measuring risk tolerance
Journal o Financial Planning, April.
Roszkowski M., Delaney M., and Cordell D.
(2004) The comparability o husbands and
wives on nancial risk tolerance Journal o
Personal Finance3:3, 129-144.
Rust J. and Golombok S. (1989) Modern
PsychometricsLondon: Routledge.
Sherin H. and Statman M. (1985) The
disposition to sell winners too early and rise
losers too long: theory and evidence Journal
o Finance40:3, 777-790.
Snelbecker G., Roszkowski M. and Cutler
N. (1990) Investors risk tolerance and
return aspirations, and nancial advisers
interpretations: a conceptual model and
explanatory data Journal o Behavioural
Economics19:4, 377-393.
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33Reerences and urther reading
Alistair Byrne
Principal, Investit. Alistair earned a PhD in
nance rom the University o Strathclyde
and is a CFA charterholder. His research has
been published in a number o academic and
proessional journals, including the Financial
Analysts Journal. He is also a visiting ellow
at the Pensions Institute at Cass Business
School.
David Blake
Dr David Blake is Proessor o Pension
Economics at Cass Business School, City
University, Director o the Pensions Institute
and Chairman o Square Mile Consultants, a
training and research consultancy. Throughout
his career, he has held a number o academic,
consulting and research positions. In 1996, he
established the Pensions Institute
(www.pensions-institute.org).
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Important inormation
This document is directed at investment prof essionals in the UK only and should not be distributed to, or relied upon by retail investors.Th i l i d i hi d i b d d b ll h li i i b ll i i i
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