In recent months we have been asked by a number of advisers what questions might be included in their firm’s assessment of a risk tolerance test. Up front we must admit that we do have a vested interest in the inclusions in such a list. After all we have spent almost twenty years thinking about risk tolerance issues and how best to manage them. So who better to get the ball rolling?

If you are an adviser, a compliance service provider, a supplier of services to financial advisers, a fund manager or life company (wishing to link risk-rated funds to risk tolerance) and are seeking a robust risk tolerance test your Due Diligence might include the following questions:

1. Who designed the test?
2. What was their financial services industry experience?
3. To what extent does the design of the test and its instructions indicate that the test publisher understands the financial advisory process and how the test results should be incorporated into it?
4. What testing discipline was used in the development of the test and who provided the expertise?
5. How have the questions being validated as being understandable and answerable and by whom?
6. How have the validity and reliability of the test been established and by whom?
7. What is the test’s track record? (For how long has it been being used? How many users are there? How many tests have been completed?)
8. Does the test have a Technical Manual?
9. Do the tests results confirm that risk tolerance is a stable personal trait?
10. To what extent have academic researchers used the test?
11. Are there any further academic studies using its core data that support the integrity of the test’s results?
12. Does the test’s publisher retain the test results for ongoing analysis to ensure quality control?
13. Has the test been used in other countries successfully or is it just local?
14. If the test is a new test to what extent can it be proved that it will perform satisfactorily?
15. Do the test’s instructions discourage adviser coaching?
16. To what extent does the test facilitate informed discussion with the client about risk-related issues?
17. How effectively can an adviser explain how the test results link to an asset allocation?
18. Does the test identify inconsistent answers and do the test’s instructions provide guidance for dealing with those inconsistencies?
19. Do the test’s instructions encourage each partner in a marriage take the test separately and explain how to manage mismatches?
20. Are there testimonials from leading industry advisers who confirm the value and effectiveness of the test to their business over time?

Advisers need to know that that the tools they use in the giving of advice are fit for purpose. That’s not just common sense; it’s increasingly being enforced by regulation.

The UKs RDR restructuring of the financial services supply train is gathering pace. While I suspect that some of the larger players have not fully come to terms with what they need to do, many of their smaller more flexible competitors are already proceeding full steam ahead.

They have made the critical decisions as to who they will work with and what they must do. In Australia, the somewhat similar FoFA reforms have been delayed, presumably after heavy lobbying form the big end of town, I wonder if a similar outcome might occur in the UK.

It’s seems to me that the UK financial advisory market is undergoing a once in a lifetime experiment. The move to a client-centric, collaborative advice process is unprecedented anywhere else in the 19 countries where we do business.

I have completed the first of the three around-the-UK investment suitability workshop tours. The ‘We are Not Here by Accident’ three hour workshops with Voyant and Nucleus proved to be a great success. Feed back during and after each session was hugely enthusiastic with particular excitement generated around the ADAPT suitability process and the usability/visual attractiveness of the FinaMetrica and Voyant integration.

I have to say I am enjoying my time in the UK immeasurably. It’s wonderful to be able to say that there is little harm and possibly great benefit in what we can do together. And of course for the first time in many years innovation is the order of the day. I have once before been part of such a major industry change. That was the Australian financial planning revolution of the 1980′s, which was the forerunner to the creation of the platform market.

I am soon to commence a tour with Aberdeen as part of their contribution to the RDR changes. I am currently preparing an ethics presentation for the IFP and an article linking the Financial Services Authority’s guidance paper to the number of clients and sums of money possibly misadvised. Also in the pipeline is a series of user friendly explanations of the Five Proofs and the ADAPT process.

My days are filled with discussions with players in the financial services supply chain exploring ways we can jointly make it easier for advisers to do business with us in the years ahead. I expect to be able to release details of the first (hopefully of several) end-to-end integrations in the next short while.

One of the challenges for small businesses such as FinaMetrica is to find the individuals within prospective integration partners’ enterprises where the three attributes to a quick and appropriate decision sit. The three are: a clear articulation of the problem to be resolved, an anxiety to resolve it and the ability to make the implementation decision. This is generally easier in small firms but in larger organisations it’s often difficult for an outsider to work out who does what. Consequently it’s an absolute delight that I have over the last while been contacted directly by representatives of larger firms who want to integrate with us.

I plan to return to Australia in late May and hope to have established a permanent UK presence for FinaMetrica before I leave.

I had a very interesting experience this morning. Our subscribers report that clients who do their FinaMetrica risk profiles typically say that it is a learning experience for them – having done so, they understand themselves and financial risk better.

Today I obtained concrete evidence of this actually happening.

I had arranged to do a webinar with a two-person wealth management firm to explain how an advisor uses clients’ risk profiles in building relationships, selecting asset allocations, etc. The two advisers, let’s call them Bill and Susie, and the customer service manager, let’s call her Jane, had each done a FinaMetrica profile. On our 0 to 100 scale, Bill scored 61, Susie scored 70 and Jane scored 41.

The last of the questions in our questionnaire, asks you to estimate what your score will be. Bill estimated 60, Susie 75 and Jane 38. Clients usually get quite close as these were.

But this is where it gets interesting! The first question in our questionnaire is,

Compared to others, how do you rate your willingness to take financial risks?
• Extremely low risk taker.
• Very low risk taker.
• Low risk taker.
• Average risk taker.
• High risk taker.
• Very high risk taker.
• Extremely high risk taker.

Bill, Susie and Jane ALL chose “Average risk taker”! Yet, by the time they had reached the final question the estimates they each made of their scores show that they had realised they were not average and now had a quite accurate understanding of how risk tolerant they actually were. Clearly, the process of doing a questionnaire had been educational in that they finished with a much better understanding of themselves.

This story is also a reminder that you can’t simply ask clients how risk tolerant they are because in this case they all thought they were average, yet there were significant differences, particularly between Susie and Jane. Susie is two standard deviations above average and Jane is one standard deviation below. Putting this in terms of clothing sizes, Susie is an extra large and Jane is a small.

And as a parting thought, we know that advisors are significantly more risk tolerant than their clients. Will advisors who haven’t tested their risk tolerance be influenced by their own idea of average when making portfolio recommendations?

My previous blog, Preparing Clients for the Ugly Times: Risk and Return, began the exploration of how we can help our clients better understand the investment experience that lies ahead.

While we might wish that this was an invariably beautiful experience, we know that things will turn ugly from time to time.

Previously we looked at how often a portfolio might be falling, recovering and rising: falling from a previous high, recovering from a previous low, rising from a previous high. Armed with this information clients will know better what to expect when they review their portfolios, in particular the likelihood that values will be falling. See full post at AdvisorOne.

As I travel, and I seem to be doing more and more in recent years, I regularly talk with advisers, compliance professionals, regulators, institutional managers and other service providers in several countries.

I am just back in Oz from a trip that included the US FPA conference, several conferences in the UK and a short visit to our business partner in Germany. All in all I was away for over eight weeks. As you might imagine, after discussing the cricket, weather differences and my jet lag, the conversation invariably turned to what is happening in the advice market. In this regard the UK is perhaps the most interesting place to be at the moment.

The UK is suffering from RDR fever. After several generations of commercial activity typified by careful and incremental decision-making the vast majority of the financial services supply chain is struggling with quick decisions requiring rapid implementation. In adversity there is opportunity. Over the next while I would happily wager that while there will be many mistakes, there will also be several careers and businesses made.

While in the UK I was involved in a number of investment-suitability activities exploring the integration of the adviser/client ‘risk conversation’ with other components of the supply chain. I describe this as the move “to develop a consistent risk language and process across the chain”. The intent: to comply with new regulation, help make advisers’ jobs and investors’ experiences just a little better. I was involved in:

• a series of ‘house full’ workshops with threesixty, probably one of the most influential advisory support groups in the land, around their advisers’ investment proposition,
• a number of intriguing discussions with a High Street bank where the executives use the language of advice as we do,
• discussions with several of the more ‘energetic’ fund managers around linking our explanations of risk into their public communications. One is in final draft stage and should be released very shortly,
• negotiations with a major investment product information supplier to provide a ‘see through’ to the underlying asset groups to match our Growth and Defensive split,
• conversations with almost all the major suppliers of cash flow modelling tools in relation to either creating or enhancing existing links between us,
• suitability clinics in Manchester and London in conjunction with Voyant, a financial planning platform. Very pleasing were the large number of fund managers, platforms, RDR consulting groups, compliance managers and other non-IFA attendees. Bob Freeman, from Voyant, and I put the clinics together at very short notice towards the end of my trip and, to our delight they were almost immediately full,
• the number of ‘discussions’, I am not sure what you call dialogue on twitter, in relation to suitability and associated issues. I am a new tweeter and enjoying the process thoroughly. You can join the discussion at @paulresnik.

What I can share is that there is a growing desire, particularly in larger organisations, to have a robust, replicable and defensible investment advice process. Simply put, they are looking for a consistent method to deliver investment recommendations. They understand that they need to provide investors with some certainty that there will have cash available to meet living costs over their lifespan. For wealthier clients, certainty revolves around the size and dispersion of their estate. The critical issue is to have a sound process for reaching investment recommendations, which is properly documented for each investor.

We might wish our clients’ investment journeys will invariably be beautiful experiences but we know that things will turn ugly from time to time.

How do we prepare our clients for the ugly times? What do they need to know?

It seems to me that what we need to do is give them a feel for the likely pattern of the experience that lies ahead. We can do this through stochastic modelling but the technicalities are likely to be overwhelming and the results’ lack of concreteness mitigates against the learning experience. See full post at AdvisorOne.

Over the last 4 years the growth asset classes have experienced extreme volatility. For many investors this has become too much to handle and many have fled to the perceived “safety of cash”.

The ability of an investor to effectively deal with the volatility of their investment portfolio is one of the key factors in determining a suitable long term asset allocation. For many investors the initial assessment of their risk tolerance using non-psychometric, traditional ‘portfolio picker’ quizzes has been found to be inaccurate. Use of these unreliable and inappropriate assessments left many investors considering themselves to be “growth” investors in the good times and “conservative” investors in the bad times. Various studies over the years have shown that this fundamental misunderstanding is one of the great destroyers of personal wealth. Investors have tended to repeat the same mistake, selling towards the bottom of the market cycle. What many investors lack is a meaningful framework from which they can make judgments about their portfolio’s likely behavior in the context of their risk tolerance.

What is volatility?

Volatility is essentially a form of market inefficiency. Market or stock volatility is a factor of supply and demand, which in turn reflects underlying uncertainty, either with the economy as a whole or with new corporate information. This uncertainty is a reaction to issues such as expected changes in inflation and interest rates, unexpectedly good or poor profits, concerns about high debt levels or default rates, the probability of some external shock and many other factors. The level of volatility which we have experienced in recent years is something that investors and most advisers are unused to.

Volatility is also a factor of the frequency of the pricing of an asset. Listed securities such as stocks and property trusts are revalued and priced continuously, whilst unlisted assets are only revalued infrequently – annually in most cases. When an asset isn’t valued continuously, by definition its current price will not change much and hence it will appear to have low volatility. Property is a good example. Listed property trusts (REITs) and unlisted property funds essentially invest in exactly the same thing – buildings and land. Yet the volatility of each is very different, as shown in the chart below.

Some volatility may have nothing to do with economic circumstances and company fundamentals, but may have a lot to do with mass psychology. The confluence of greed, fear and disagreement on the interpretation of new information can give rise to extreme price fluctuations. During the GFC, for example, the prices of commodities, stocks, derivatives, property, bonds and currency all gyrated wildly. No one seemed to know what the “right” price for anything was. This high level of uncertainty regarding the “right” prices was so profound that volatility in most asset classes was driven to an all time high.

Volatility changes over time

The chart above also shows that volatility is not a static thing. The listed property sector, for example, has had periods of extremely high volatility, (1989-1990 and 2007-2009), along with periods when volatility appeared relatively benign (1990-2007). Investors should be very wary when volatility is averaged out over a number of years and presented as a single number, because this will be totally misleading. It is better to look at a chart like the one above which gives a far better understanding of how an investment can bounce around in value over time.

The limitations of volatility as a measure of risk

Because standard deviation is easy to calculate, the finance industry has tended to use it as a proxy for risk. However, volatility only measures the variation of returns around the average long term return. Volatility does not indicate how much money an investor might lose, or how long it will take to get your money back. Nor does it measure how frequently periods of negative returns might come along.

Low volatility does not mean low risk. In fact, low volatility can obscure the fact that risks are building up in an investment. Recent history shows us that low volatility can coexist with very high inherent risk. The Basis Capital Yield Fund is a good example. This now notorious investment was marketed as a low volatility fund with risk akin to a “normal” fixed interest investment. However, a closer look would have revealed that the fund was highly leveraged and substantially invested in illiquid securities such as CDOs, comprised of assets of highly dubious quality. In the period leading up to the GFC, these securities happened to have very low volatility, precisely because they weren’t being traded often and could not be valued accurately. When the market for these securities collapsed during the GFC, the real risk became all too evident and the value of the assets in the Fund fell to virtually zero. In the same vein, investors should not be lulled into thinking that unlisted property is low risk, just because its volatility is low. You can lose money in unlisted property too!

Volatility isn’t forward-looking and does not predict returns. The volatility of the Australian share market was at historic lows immediately before it crashed 40% during the GFC. It would have been a mistake to have increased your allocation to Australian shares in late 2007, in the belief that the prevailing low volatility indicated the share market was “safer” and this situation would continue indefinitely. To complicate things further, it is not unusual to get mixed signals. Good returns can be made in periods of both high and low volatility. Similarly, big losses can be made when volatility is both high and low.

Final thoughts

The past few years have been unusual, but not unprecedented. A historical perspective shows that periods of high volatility are normal and can extend for some time. Many investors who had assumed the previous years of extreme low volatility were the normal condition and indicated a less risky environment were surprised by the change and the impact it had on their wealth. A true understanding of volatility and its limitations as a measure of risk provides a more rational perspective and can help investors make better decisions about their investments.

The challenge for the industry going forward will be to re-engage and re-educate with those investors that have fled to the perceived safety of cash.

Are you uncomfortable with the way your firm’s advisers match investments to clients’ needs? If you are discomfited, you are not alone.

Regulators, and by default advisers, around the world are paying increasing attention to the logic and rationale used to reach investment recommendations.

FinaMetrica has historically worked with high-end, predominantly independent financial advisers, mainly in the US, the UK and Australia. Many share a common investment suitability process. In the UK it’s largely consistent with the Financial Services Authorities Guidance on suitability and in Australia it’s consistent with the Financial Ombudsman Service’s approach to complaints assessment.

This is my understanding (and simplification) of their practice. Pleasingly, it is also largely consistent with, and perhaps a little more intuitive then, the processes we outline in our education materials. See our QuickStart Guide, page 14. I have broken the process into five stages. To make the whole thing a little easier to remember I have developed the acronym ADAPT. Not only does this take something from the imperative for having a business model that meets the new needs of both clients and regulators, it’s also relatively easy to remember.

ADAPT

Awareness of risk tolerance. This is simply asking the client to read and think about their risk tolerance report, generally before the first meeting with their adviser. If client has a life partner, it’s also suggesting that they sit together and talk through the similarities and any differences in their reports which might reflect how they manage money and make financial decisions in their lives. This means they come to the first meeting with an understanding of their risk tolerance compared to each other and the general population.

Discussion of the risk tolerance report. The adviser talks through the report with client(s), specifically exploring individual differences and differences between any partners. Many advisors have told me that this is the time when client and adviser rapport is first established. It’s the “Aha moment” when an in-depth client-adviser relationship is born. The report forms the basis of the client’s instructions to the adviser about the level of risk they would prefer to take.

Asset allocation link to the agreed risk score. The adviser converts the client’s instructions to an asset allocation which in turn can be linked to a portfolio that can be tested against the client’s goals. FinaMetrica provides a detailed methodology to link risk scores to portfolios, see Linking Spreadsheet. Many advisers use this as the starting point for a collaborative/ iterative planning conversation that takes into account prioritisation of client’s needs and life style choices. The link is the single most often-raised issue in my talks with advisers and others in the supply chain.

Project forward the range of performances of that asset allocation/portfolio to show client(s) the likelihood of their liabilities being met as they fall due. It’s possible that the portfolio consistent with risk tolerance is different from the portfolio required to meet the client’s needs. It’s also possible that the client has a risk capacity that is less than consistent with that portfolio. The plan resolved also needs to take into account the client’s alternative spending, working and investing capabilities.

Test client(s) understands the risks. Explaining risk is not easy. The statistical information that advisors work with – mean, standard deviation, confidence intervals, likelihood of a negative return and so on, is not readily digestible by the typical client and is unlikely to give them a meaningful understanding of what lies ahead. Clients need to have a feel for the patterns of portfolio performance that can be expected over time. Here, the past is a great ‘tool’ to illustrate ups, downs and outcomes. Advisers can show how the recommended portfolio has performed in the past. The goal here is to frame investment expectations such that clients are not surprised by their portfolio’s future returns and volatilities, particularly by extreme events, see Risk and Return Guide.

ADAPT is a critical component of the shift from product-centric sales processes to one where advice leading to a client’s informed consent is the new norm. Consequently, most players in the chain, other than a small number of already compliant IFAs, are enjoying an unprecedented opportunity to manage their own change.

I am very keen to receive comments on ADAPT. To kick off the conversation:

• What are its weaknesses?
• What needs to be clarified?
• What alternative approaches to it are there?
• How best to communicate it.
• Who else in the supply chain should we be talking with?

Understanding a client’s risk tolerance is clearly a key element of the professional financial planning process, in addition to being an established part of the ‘Know Your Client’ responsibilities.

However, just as the UK was suffering its coldest winter in decades, the regulatory heat was turned up with the publication in January 2011 of an FSA ‘Guidance Consultation’ paper. Half of the cases they reviewed over a two year period had failed to meet minimum standards, simply by not matching the clients’ needs in terms of investment risk.

Examples of ‘good’ and ‘poor’ practice were provided, but the regulator stopped short of offering a blueprint on how to meet the requirements. This is a good outcome, in that we support any attempt to improve the quality of advice but dislike regulation which is too prescriptive. We did however feel the need to document and justify our risk assessment process in some detail. The following paragraph from the FSA’s paper does not leave much room for interpretation:

‘As we apply our intrusive and intensive supervisory approach, we will be looking to see how firms have acted on this report. We will consider, for example, whether firms have robust procedures, tools…and check the level of risk a customer is willing and able to take, as well as assessing the suitability of investment selections.’

This exercise has actually proved to be very useful in clarifying our thinking and has forced us to reflect harder on a number of issues, including the rationale for having initially selecting FinaMetrica as a supplier.

We chose to focus on three main criteria in order to validate our selection of a risk tolerance assessment tool:

• Independence of the tool and provider;
• Credibility of the questionnaire;
• ‘Fit’ with our overall advice process.

Independence of the Tool & Provider

The key reason for seeking an independent solution is that we want to offer a consistent advice process which should be entirely agnostic as regards the ultimate product (if any) that is selected to fulfil each client’s needs.

The following comparison, which we carried out in 2008, shows the potential danger of mixing and matching different risk profiling/asset allocation tools from different product providers; the asset allocation derived for a ‘medium risk’ investor varies hugely from one tool to the next. It also demonstrates the clear lack of consistency in the risk tolerance assessment methodology and/or the translation of risk tolerance into a recommended asset allocation.

The FSA has additional concerns in this area, as it would not want an adviser to become ‘dependent’ on a product provider on the basis that its tools become a core part of their investment process. If this were the case then the adviser’s judgement on product suitability could potentially be impaired by the software relationship. It is also suspicious that provider risk tools, which result in an asset allocation, can unduly favour in-house products.

Credibility of the Questionnaire

A problem with many industry tools is that they appear to have been constructed without regard to psychometrics. Most use between 8 to 15 questions, so their results are probably neither valid nor reliable from a statistical perspective.

In some tools we reviewed, questions deal with matters such as investment time horizon, whether the investment is for ‘income’ or ‘growth’ and so on. It is clear that, in order to generate an asset allocation which is based on a single set of questions, these tools are conflating advice issues which are unrelated to risk tolerance.

FinaMetrica is one of the very few commercially available tools which have been independently validated as complying with international psychometric testing standards.

‘Fit’ with the Overall Advice Process

We believe that a risk tolerance questionnaire should be completed at an early stage in the advice process, without the initial ‘assistance’ of the adviser. Where more than one client is being advised, the risk tolerance of all individuals should be measured independently.

From this point of view, the ability to email all clients a FinaMetrica risk questionnaire before the planning process has started fits our business perfectly. And from a commercial perspective it has also worked well, particularly in terms of improving the perception of our professionalism.

The resulting report provides a firm basis for a more informed client/adviser discussion at the initial meeting; detailed notes are taken and the resulting agreement is signed by both parties and scanned onto our client files. This mitigates the risk of selective memory and lawsuits down the line.

One of the drawbacks of many risk profiling tools is that they are inextricably linked with a proprietary asset allocation process which does not fit with our portfolio construction methodology. In particular they rely on a mean variance optimisation process which appears highly scientific, but in reality is opaque and adds no real value over the growth/defensive asset allocation approach which we advocate.

FinaMetrica’s outputs fit well with our investment procedures, enabling us to create a consistent, end-to-end process which doesn’t de-personalise the advice, or shoe-horn clients directly into a model portfolio.

Many attitude-to-risk questionnaires also lack scientific rigour as regards the positioning of each risk category on the ‘efficient frontier’. Where is the evidence that a portfolio with any given volatility/expected return profile will match a client’s expectations, based on their answers to a set of risk tolerance questions, no matter how well constructed?

FinaMetrica has helped us address these concerns through its study of risk and return outcomes and its highly-informative client education material.

A further issue is the need to adapt the client’s risk tolerance to take account of their risk capacity, or the risk required to meet their investment goals. This sits at the core of what we do as a business.

At Pilot Financial Planning all personal clients are taken through a comprehensive lifetime cash flow planning exercise, using the Voyant software, with which FinaMetrica has been integrated. This enables us to address all the key planning issues without confusing these different dimensions of risk.

Where a discrepancy occurs between a client’s risk tolerance and their risk capacity or requirement, we are able to explore a range of scenarios and agree the best compromise solution. Again, we document this agreement for the avoidance of doubt in the future; something which is particularly important where the client has made the decision, after discussion and challenge from the adviser, to increase the level of expected risk and return in their portfolio to a level above their psychological ‘natural’ risk tolerance.

In summary, we are comfortable that the use of FinaMetrica, as part of our overall advice process, not only strengthens our client proposition, but also de-risks our business. We also feel that documenting the risk assessment process and the rationale for selecting external software suppliers would be a useful exercise for any business which has not yet done this, regardless of the regulatory imperative.

First, an admission. Paul Resnik and I like the people who run small businesses. It’s probably because they are like us: interested in the world and ambitious to change it for the better.

The conference is simply stuffed full of such people. Self-driven individuals who have got off their backsides and travelled: some from distant continents, some from the far reaches of the US and some from just around the corner.

What brings us together is a combination of commercial intent, the search for professional integrity a hunger for knowledge and the collegial atmosphere. In my case I have been travelling to US industry events for more than 10 years and I am still excited by the energy and opportunity that permeates these days.

Paul and I do not get to as many sessions as we should. Too many people to talk to. But the ones we do find time to attend are often inspiring. In the depth of the economic malaise that has enmeshed the US there are individuals and businesses that have great stories to tell and inspiring ideas to share.

Best of all are the sometimes hurried conversations with delegates bustling from one session to the next. The thank yous from strangers, “We have been using you for the last five years and you have made a big difference to our business.” A quick hand shake and they are gone. We are a web business. We market on the web. We sell on the web. We service our clients on the web. We are probably one of the longest surviving web businesses. But we do not get to meet our clients all that often in person. I probably do not need to tell you what a fantastic feeling it is to be appreciated by people you respect.

This year we walk away with a feeling of optimism. Professional financial planners are playing an ever more important role in the wellbeing of their local communities. In these times of growing distrust in the primary limbs of our societies – governments, banks and the media – good planners are a light on the hill. They are good people. We are proud that we can make a small contribution to their success.