Assessing a client’s risk profile – that is, their natural feelings about risk – is a fundamental step in the financial planning process.
It usually happens early on in the process, once they are engaged, and is usually assessed initially using a questionnaire. This involves evaluating an investor’s willingness and desire to take on financial risk, which is a crucial factor in determining the most appropriate financial planning and investment strategy.
There are a number of risk profiling tool providers out there – some of which are built into bigger systems offering fund and product research, report writing, as well as risk profiling, whereas some providers specialise in only offering a risk profiling tool. Or at least under the brand of the risk profiling tool.
Do we need to use a tool to assess a client’s natural risk level?
The Financial Conduct Authority (FCA) does not prescribe how firms must assess clients’ willingness and desire to take on financial risk; however, their Assessing Suitability paper states that firms must:
- ·Assess the risk a client is willing and able to take.
- ·Check with the client that the firm has correctly identified and understood the risk they are willing and able to take.
- Consider whether the client is able financially to bear any related investment risks consistent with their investment objectives.
- Consider whether the client has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of their portfolio.
With the above in mind, it’s clear that firms must ensure that they have a robust process in place that is fit for purpose. Whilst there is no official requirement from the FCA to use a risk profiling tool, tools and questionnaires can help to provide structure, promote consistency and support discussions about investment risk.
Of course, the use of a tool in assessing a client’s natural risk level is only one part of actually determining a suitable level of investment risk for a client to take; however, here we will focus on that initial process potentially involving a risk profiling tool.
With an abundance of risk profiling tools available in the market, it becomes crucial for Financial Planners and Paraplanners to carefully review and select tools that are fit for purpose. This includes doing full due diligence on the chosen tool and assessing whether using the tool provides value as part of a firm’s overall proposition.
As we do with Centralised Investment Propositions and Platform Due Diligence, we complete whole-of-market research on areas such as risk profiling tools and approach it in a similar way.
Some of the key areas I focus on when reviewing the risk profiling tools available on the UK market include the following.
1. Is the tool a standalone risk profiling tool – does it come as part of a piece of wider financial planning software?
Many risk profiling tools, such as Dynamic Planner or EVPro, come as part of wider financial planning software. Both standalone risk profiling tools and those integrated into wider financial planning software have their merits.
Whilst some Financial Planners may welcome access to all the bells and whistles, like fund research or cash-flow modelling, some may be already using FE Analytics or Voyant and, therefore, will not require access to the additional features. In such cases, it will be more practical to look at standalone risk profiling tools. These are often more cost-effective because they are designed to serve a specific purpose: assessing a client’s natural risk level.
Financial planning software packages that include a wide array of features may come with a higher price tag, which might not be justified if the additional features are not extensively used or needed.
2. What does the questionnaire look like and how user-friendly is the tool?
The tool should have well-designed and easy-to-understand questions that encourage clients to thoughtfully consider their feelings about risk and their natural reactions.
During my most recent review of the market, one tool in particular stood out as being extremely engaging. This is a tool built by Be-IQ, which is relatively new and not used widely as yet but has interactive elements that make the process more engaging, helping clients actively participate and giving Financial Planners a better understanding of clients’ natural risk levels.
Engaging clients interactively is a valuable aspect of the user experience. The tool should also have an intuitive design, making it easy for clients to navigate through the assessment process. An intuitive interface can enhance the overall user experience, reducing the likelihood of errors and ensuring that clients can seamlessly provide the necessary information.
3. What is the methodology used?
A robust risk profiling tool should be grounded in well-established behavioural finance principles; understanding how investors react to various market conditions, as well as understanding their biases and risk perceptions, is vital.
The methodology should draw on research in behavioural economics to capture the complexities of human decision-making, and some tools should incorporate psychometric assessments to understand the psychological traits influencing decision-making.
This can include factors like risk aversion, loss aversion and time preferences. Psychometric insights complement traditional financial data, offering a more holistic view of a client’s natural risk level.
4. Which funds or Model Portfolio Service (MPS) providers do the risk profiles produced by the tool map to?
Not every risk profiling tool will map its risk profile results to the portfolios that form part of the firm’s Centralised Investment Proposition (CIP) or Centralised Retirement Proposition (CRP). However, for those tools that do incorporate this mapping capability, the advantages extend beyond mere convenience and efficiency. With the introduction of PROD, every firm should deliver consistent outcomes for customers who are in similar circumstances, and when risk profile outcomes are directly mapped to portfolios within the CIP or CRP, it enhances the transparency and consistency in the financial planning process.
This, of course, does not mean that the result that is determined by the tool is the one that is right for them, but the majority of firms will use that as a starting point and then agree a suitable level of risk based on the other risk profile outcomes of the tool.
5. What do the risk profile outcomes and suggested asset allocations look like?
Including risk profile outcome descriptions and suggested asset allocations is highly beneficial for several reasons.
Risk profile outcome descriptions can provide clients with a clear and concise explanation of their natural risk level. This descriptive information helps clients understand the implications of their natural risk profile in terms of potential gains and losses, and without descriptive information, clients may misinterpret their natural risk profile solely based on numerical scores. Descriptions add context and nuance, ensuring that clients comprehend the meaning behind their results and its relevance to their financial goals.
In addition, asset allocation becomes particularly valuable if the chosen risk profiling tool does not directly map the chosen suitable risk profile with the firm’s CIP or CRP. This will enable the Financial Planners and Paraplanners to manually map the chosen risk profile to the suitable portfolio, ensuring a seamless integration of risk assessments into the broader investment strategy. Obviously, there might be other factors than purely asset allocation to consider, but this is a good starting point.
In conclusion, the careful selection of a risk profiling tool is crucial for effective financial planning. By considering factors such as features, costs, user-friendliness, methodology, alignment with model portfolios, risk profile descriptions and suggested asset allocations, Financial Planners can ensure they choose a tool that is fit for purpose.
This approach not only enhances the financial process but also contributes to building stronger client relationships and delivering tailored, quality Financial Plans.
