Better Business: Top tips on risk profiling

It is only March, and the FSA has twice this year fired warning shots over risk profiling. So how should you respond?

Start by having an honest look at what your business does today. IFAs fall into three camps: those who don’t formally risk profile at all; those who use a ‘portfolio picker’ questionnaire; and those who use a structured, goal-based approach.

Truth is, the FSA does not care which camp you are in; it cares about the link between your client and their portfolio.

If you can prove – with written evidence – that Portfolio X suits Client Y then how you get there does not matter. It may be possible for an IFA with no structured process to establish that link, but it will not be easy. You are more likely to derisk your firm with a consistent and rigorous process.

Advisers in danger

Those advisers in the most danger are those who think they are covered because they use an off-the-shelf questionnaire. Do you know how the questions it contains were derived? Their statistical validity? Have you tested how easy they are for clients to understand? And even if these tools can correctly work out ‘who’ is in front of you, do they point them towards a suitable portfolio?

Let’s break risk profiling down. It is not one thing, but three. That is one of the key messages in the FSA’s recent guidance. Treating ‘risk profiling’ as a single entity to be noted and recorded, like a client’s shoe size, is a mistake.

The three things are risk tolerance, risk capacity and goals. A good risk profiler not only examines each one individually, but provides a way for the adviser to reconcile the three: they will rarely all match each other.

Risk tolerance

Risk tolerance is where most risk profiling tools start; sadly, it is also where most of them end. A well-constructed tolerance questionnaire can accurately place a client into ‘bands’ based on a scientific discipline called psychometrics, literally ‘measuring minds’. The language of the psychometrics community is arcane; luckily, we do not need to concern ourselves with ‘Cronbach’s alpha’ and ‘construct validity’.

We just need to know that a proper process was followed when deciding which questions to ask, and that evidence to support those choices is on file. A surprising amount of analysis is required to arrive at ten simple tolerance questions; only a tiny minority of experts are able to do it well.

Discovering a client’s willingness to bear risk is dangerous in isolation. Mental aggression can be found in clients with no financial ability to take losses, nor any need to bear a level of risk. The FSA seems determined to stop the sort of primitive thinking that goes “aggressive personality equals aggressive fund”.