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Risk profiling is an important ritual of assessment every investor must go through before they choose their investment scheme. Considering the volatility of the stock market, it is vital for investors to know the risk involved- for example, the amount of risk they are willing to take, the amount of risk they are capable of taking, the amount of risk they think they are capable of taking, and how they will respond to market fluctuations. Classifying investors based on risk levels will help in deciding how the investment must be divided between the asset classes i.e equity, debt and money market.
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All financial management companies and financial advisors are involved in the practice of profiling prospective investors for risk. But, as behavioral economics puts it, human beings are irrational beings, and may make decisions not in their best interests. And these irrational decisions are based in certain biases, both cognitive and emotional, centric to human nature, as we discussed in the last article.
For example, if an investor is overconfident they can take a significant investment risk and turns out they can’t, it might not end well. Or, an investor may buy when the market value is high and, when market value is low, sell off in a panic.
So is investor risk profiling, as we know it now, equipped to handle the treacherous and unpredictable nature of investor behavior to produce the optimal outcome possible?
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It seems not.
There are several problems in the way risk profiling instruments are designed today. Let’s see, one by one, as to what they are:
Ambiguity in terminology: A lot of the time, questionnaire designers seem to think terms like risk tolerance, risk perception and risk capacity are interchangeable- which is not the case. They’re distinct terms, and each needs to be evaluated separately.
Legislative ambiguity: While financial regulatory bodies have made laws around risk profiling, the apparent wording of these laws leaves a lot open to individual interpretation by finance companies.
Questionnaires are too simple: Most questionnaires have very generic, basic questions, which do not include, or attempt to include, questions which can capture the investor’s behavioral traits. Questions are linear, based on single measurements.
Lack of understanding of risk profiling at a deeper level.
Seems like financial consultants/advisors are not able to incorporate behavioral finance based risk profiling into the client onboarding process.
Online investing platforms taking the shortcut, quick fix approach to ‘know your client’ without going deeper into investor psychology.
One dimensional approach: Most risk profiling questionnaires right now have a one-dimensional approach. They just ask about the willingness and financial capacity for bearing investment risk. Most commonly, questions about time horizon, need for income or growth, and attitudes about risk and market volatility are put into use, a risk score determined, and the investor assigned a portfolio matching risk level. This approach combines together risk capacity and risk tolerance- which, in turn, might result in a portfolio with incongruent capacity and tolerance- for eg, someone with low capacity for risk might get a portfolio with high tolerance.
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These screw-ups are not mundane issues which can be ignored- they’re grave issues that are not just landing investors in a soup, financially speaking, but also putting financial advisors and companies in a fix- legally speaking.
Let’s take the instance of Canada. A study done by PlanPlus, a research firm, for the Ontario Securities Commission ( OSC), found that 83% of risk profiling questionnaires in the Canadian market aren’t up to the mark. It found that questions are too few, poorly worded, have arbitrary scoring models, and a lot of them seemed to be directing the investor towards a certain product. See if the investor feels that their advisors/finance companies managing funds have led them into the wrong investment, this can lead to the investor going to regulatory bodies like OSC with complaints- and disputes over risk profiling are the top complaints it gets.
So what can be done to make risk profiling questionnaires behavior-savvy in a way that optimizes investor outcome?
Risk tolerance and risk capacity must be evaluated separately.
The answer is a two dimensional assessment method.
Academically, people studying consumer behavior are converging on three core constructs of risk profiling:
Risk tolerance: A client’s willingness to take on risk, knowing that a negative result could occur.
Risk capacity: This is a measure of how financially able a client is to endure a potential financial loss, while still being able to achieve their financial goals. Whether goals are achievable depends on what the goals are. Some goals are so aggressive that they demand a greater amount of risk than usual- also known as risk need. Risk capacity and need have to be separately evaluated from risk tolerance.
Risk perception: This is a measure of how risky investors think the markets, or their investments, are. If the reality turns out to be way different than the perception, investors may react in a surprising, unpredictable manner- this is called risk composure, and differs a lot between investors.
While risk tolerance and perception are subjective parameters, risk capacity is an objective one. Combining both, the risk profile must be calculated, which must then be mapped on to a feasible portfolio, tailored to the investor’s tolerance, capacity and goals. There is still the challenge of predicting actual consumer behavior in times of upheaval, but by using the science of psychometrics- theory and technique of psychological measurement- an effective risk tolerance questionnaire can be designed.
Much more pragmatic would be to include these tools in some kind of best practices or standard operating procedure- a standard set of guidelines which financial advisors/ companies can adapt to their own business models.
So what can these guidelines be? Let’s take a look.
As already mentioned, risk tolerance and risk perception must not be confused with risk capacity, and investment goals.
Don’t confuse short term investor behavior as extrapolated long term investment goals.
Don’t require respondents to have knowledge of finance or investing.
Don’t require people answering questionnaire to perform complex calculations or probabilistic reasoning.
Don’t mandate investors to keep up with current market conditions
Don’t rely on future behavior or expectations more than risk tolerance.
Use statistical and psychometric tools more rigorously in questions.
Questions by their nature must distinguish between individuals, and not be a one-size-fits-all affair.
Once financial advisors and companies modify their approach to risk profiling, a more rigorous and competent method of helping investors understand their risk profile, as well as helping advisors and companies learn about their own biases, can be put into practice. A deeper understanding of risk profiling terminology, plus weaning away from the traditional approach to a new approach which uses more of behavioral finance methods checking for investor bias, can optimize results both for investment management companies and investors.
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At JubiAI, our third interface solution powers super-bots at some of the largest financial services businesses. Investor behavior, profiling and personalization remain the key components to our approach towards designing systems that increase engagement and ROI. More about us here : www.jubi.ai