In the last few years the UK financial advice sector has undergone significant changes. These range from an increase in regulatory obligations to the changing expectations of investors towards transparency.
Author Andre Correia
Date 24th August 2016
There has also been an increase in engagement when investing, typically through online services. As a result several key topics have been in the forefront of the sector, and none more so than suitability.
Ensuring suitability is being able to demonstrate that a particular investment is suitable to the investor, in terms of matching:
- Their willingness to take risk (Risk Tolerance)
- Their personal circumstance and ability to bear the possible losses (Risk Capacity)
- The expectation of return will enable them to achieve their goal in the desired time horizon
If an investment ticks those three boxes, and the investor is able to understand the risks involved and agree to the investment, then the investment is deemed as suitable. Traditionally, the sector has focused primarily on the last component – engaging with the investor with an expectation of the investment’s performance, then ‘solving the equation’ of delivering what goals they would like to achieve. This engagement step, which is akin to planning with the investor their return and cash-flow expectations, will remain a crucial component of ensuring suitability – whether the engagement is conducted face to face with an adviser, or through an online interface. It is less encouraging to find a significant disparity in the approaches taken to address suitability when it comes to Risk Tolerance and Risk Capacity. Many in the sector erroneously believe that these components, driven by statistical analysis, are meant to replace the engagement process by providing a simplified ‘one size fits all’ answer to suitability. This belief, whether critical or complimentary, is mistaken – ensuring suitability through Risk Tolerance and Risk Capacity is essential to understand the trends behind investor preferences, and provide consistency to the engagement process.
Risk Tolerance is Static, Risk Preferences are not: Assessing the preferences of risk tolerance groups
Risk Tolerance, or the willingness to take risk, is measured in a standardised way throughout the sector, through the use of psychometric methodologies. This method of statistical questioning and discovery of underlying psychological traits, has been around since the 19th century. It is a very useful, consistent, and accurate way to provide a simple classification of investors in a relative scale. On a 1 to 5 or 1 to 10 scale, we can immediately know that an investor in ‘category 3’ will be generally be less willing to take risk than those in higher categories. Better psychometric assessments are designed to ensure that score remains very reliable over time. Thus, unless something very significant occurred in an investor’s life (e.g. bereavement or retirement), the vast majority of people will remain in the same category year-on-year. This level of consistency and reliability is useful in the risk profiling process, but only when there is a subsequent process to capture risk preferences – the actual level of risk people in any given risk tolerance category would generally prefer, all things being equal. Unlike risk tolerance, risk preferences are not static; people will change how much risk they wish to take much more frequently, as markets and economic cycles come and go.
A good example to illustrate this, is to take an investor, with a risk tolerance of 3 out of 5. In that relative scale, the person has ‘average’ tolerance for risk. If we assume that person is not approaching retirement, and has no unexpected changes to their circumstances, then it is highly likely that they will have been and remain a 3 on a risk tolerance scale for the foreseeable future. We must then consider their risk preferences at any given point in time. In 2007, for example, at the height of the ‘bull market’, it is likely their preference for risk was higher than a year later, as the financial crisis started to unfold. One more year hence, their preference for risk would most likely be even lower, with market performances hitting lows and investors globally losing money.
In the changing scenarios of this example, an adviser trying to establish a suitable investment strategy would have had to conduct a very thorough engagement process to be able to ensure their advice was in some way aligned to the investor’s risk preference. The ‘3’ category that was relevant a year prior would have been changing their expectations and preferences, significantly, so without any assistance from a risk profiling process, suitability was very difficult to demonstrate.
Most year on year changes are not so dramatic, but the point stands: Risk Tolerance will be stable and preferences will not. As such, the first step in assisting with the suitability requirement is to correctly identify risk preferences – over time – and align them with each risk tolerance category.
The Oxford Risk process relies on understanding the range of investment solutions: whether they are defined as portfolios, funds, or otherwise, and then testing investors of all risk tolerances for their preference between adjacent investment alternatives. The questions that populate the analysis are displayed graphically, and have been validated by The Department of Behavioural Finance at The University of Oxford to ensure that all potential investors can understand the choice presented to them. Aside from these ‘choice preference’ questions, respondents are also provided a risk tolerance assessment. Once a statistically significant number responses are accrued, it is possible to mathematically determine the relationship between risk and reward people in any risk tolerance category. Visually, this is represented by an expected utility curve:
The graph above is an example of an expected utility curve for a given risk tolerance category. For each additional measure of risk, represented on the x-axis as volatility, the y-axis will reveal how many people in that category would be happy to take that level of risk. The level that can be deemed generally suitable is the one that satisfies 50% of those individuals. In the graph above that point is just under 4% volatility for all time horizons, 5 years, 10 years, and 20 years.
The preference for risk, as informed by the analysis, is telling in several ways:
- The preference for risk will be different depending on the time horizon. The example above shows a very similar set of preferences, yet it is distinguishable that investors generally prefer more risk over longer periods of time. Oxford Risk has observed than when people are more fearful of loss (as they were in 2011 when compared to 2016) they will reduce their short-term preference for risk significantly. After all shorter investment periods don’t allow enough time for corrections in expected performance if the markets are in decline.
- Risk preferences will change over time, as sentiment and market conditions change. Preferences showed that in 2011 investors as a whole wanted less risk than they are willing to take now. In the example above, the suitable solution lies close to 4% volatility; in 2011 it was 3%. As appetite changes, the position and gradient of the expected utility curve will change too, to capture the direction and extent of the new risk preferences for people in that risk tolerance category.
- There is no one size fits all solution. When viewing preferences displayed through expected utility, you get a sense of the distribution of those preferences. Certain investors will always want a lot of risk, regardless of their risk tolerance. While others will be unwilling to invest at any level of risk. The analysis can inform of the suitable level – the generally preferred 50% point, but it is only through the consideration of Risk Capacity and subsequent engagement with the investor, that an adviser can assess if a particular investor should take more or less risk. In some instances, capacity will be the dominant factor, for instance for high net worth individuals, and for others their goal and its importance. The analysis can consistently inform an ideal starting point for the Risk Capacity and Engagement steps in ensuring suitability, and quantify the final decision in a way that the investor can understand:
‘An investor was shown portfolio B, which was generally suitable to the people in their risk tolerance category. However, the final portfolio selected was C. This higher level of risk would only be acceptable to 35% of investors in that risk tolerance category, however the risk capacity and goal objectives of the investor were better met by portfolio C. The investor understood the deviation, and that they were increasing their risk in relation to their peers, and how it was the most suitable decision to make in light of their circumstance.’
Oxford Risk has had a specific process to establish empirical suitability for a number of years, one which has proved exceptionally popular with our own clients, and which goes further in understanding the risk preferences of investors.
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