The concept of mapping the outcome of a risk tolerance assessment to a range of suitable investment solutions has become a key concern for advisors and ‘Robo-advisors’ alike
Author Andre Correia
Date 6th September 2016
The challenge of ensuring ‘suitability’ is one that has been addressed in several ways by the industry. Unfortunately most of them are lacking validity in some respect. We have noted some concerning approaches to suitability that can be found today:
‘Select your own’ Suitability
This method was the status quo of the industry pre-RDR, and unavailingly it is still widely used as part of some risk profiling processes. Without any actual measure of risk preferences, it will always be difficult for an advisor to ensure and defend the suitability of their advice. However, if no such information is available, the advisor will be better placed than anyone else to make that judgement. A risk profiling process that makes no effort to inform or guide the advisor with defensible outputs to ensure suitability is providing a great deal less less value than the established best practices. The most unhelpful services ask advisors to self-select which of their established solutions maps onto which range of risk tolerance outputs, explicitly placing all responsibility and suitability expectations on the advisor’s subjective opinion with no support offered.
Subjective Relative Suitability scale
This process is far more common in the industry, and does provide some intuitive reassurance that major glaring mistakes when ensuring suitability can be avoided. It relies on the creation of a scale to rate available solutions or funds against each other, typically ranking them in buckets or categories that distinguish them in a relative scale of risk. Many research and fund providers either create or affiliate to these comparative scales as a means to ensure suitability. The main issue arises not from the scale, or the rank between solutions and funds it creates, but rather its very simplistic and subjective mapping to a risk tolerance scale, with a 1 in risk tolerance being directly mapped to a 1 in the risk scale. It is important to be familiar with how the output from risk tolerance is mapped to suitable solutions, and any process that is subjective and simply puts the two relative scales together is not going to satisfy the suitability requirement. For example, low risk investors are aligned to low risk solutions, avoiding obvious unintuitive outcomes, however, the actual level of risk they delivered has not been tested with investors; it may yet be delivering an unsuitably high or low level of risk.
Some providers have established seemingly analytically sound processes that establish forward looking suitability on the basis what level of risk has historically been delivered to investors in each risk tolerance category. This approach again can provide some intuitive results, as risk averse investors are naturally presented with the low risk solutions. However, the main issues with this method remain: there is no actual testing of investor preferences, where choices are portrayed to them and an assessment of what choices they make in relation to the risk/reward dynamics on offer. Therefore there is no way of ascertaining if the levels of risk provided by this method actually align to risk preferences, or indeed if they so not and the result simply reflects an incorrect subjective mapping. Furthermore, past levels of risk are no indication of current (or future) suitable levels of risk. Without testing there are far too many uncertainties to be able to demonstrate that a defensible and sound suitability process was used.
If this seems similar to your current suitability process, please do bear in mind the relative risks of using these approaches, and that they will not provide you with the consistency and reliability of results as efficiently as existing best practices. If you are unsure of the merit of your existing approach, there are a couple of critical questions to consider:
‘Have preferences been tested, where investors have to decide between two or more realistic and different investments (and their forward looking expected performance)?
Does the suitability approach ensure that preferences are updated at least yearly? Risk Tolerance is likely to be stable over the majority of an investor’s life, but their risk preferences and thus the level of risk they may prefer can change each time they choose to invest.
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