The Paraplanners

Risk profiling tools - part 1 Wed 24 Aug 2011

The whole issue of risk profiling has always been of great interest to me and the FSA has stimulated much discussion on this subject with their recent proposed guidance (which I think is one of the best and most useful documents they have produced).  I have been meaning to write a series of posts on this subject for a long time, well a couple of years actually, and this one sets the scene. 

As some of you may know, my business has launched a simple cash flow planning tooland we are going to be talking a lot about how a cash flow can form the basis of a robust risk assessment process on the Moneyscope blog shortly.  I am also speaking on this subject at the IFP Conference in October so, if you are interested and going to be there, please come along and add your own views.

I have been researching this subject for a while and so some of the information in this series is out of date but the results are all still valid and hopefully useful to you.  I intend to write the following blogs:

  1. Background and the "problem" (this post)
  2. Results of our survey on the tools advisers use
  3. What a robust process could look like including the MI you should be keeping
  4. How cash flows can help

That's the plan although it might change as we go.

About two years ago my firm did some research into the main risk profiling tools available to IFAs in the UK focusing mainly on the variability of the outcomes.  My main concern was the difference in the suggested asset allocation the same client could end up with if their adviser used different tools.  In addition, from a TCF perspective, if different advisers in the same firm used different tools, the outcome would be different (significantly in some cases) for the same clients and that is not a robust, repeatable process at all.  The position is even more complicated if the same adviser uses different tools for different clients without a very good reason.

I often use the example of twins to highlight the potential issue here.  Identical twins come into the office with identical views and objectives both having £100,000 to invest.  Twin one sees one adviser who uses the risk profiling tool from company A and twin two sees another adviser who uses the risk profiling tool from company B.  Both advisers base their recommendation on the result from the respective tool and create a very tax efficient structure with high quality funds and the twins leave the office. They come back a year later but are no longer identical in every way as one twin is now poorer than the other due to the difference in the asset allocations driven by the tools. This is a hypothetical example to illustrate the point but this is not TCF - i.e. the same client with the same objectives should have the same outcome.

So, here are the results from our research.  We approached this by putting the "same client" through the various tools to see how the results differed.  This was not scientific but to try and be as consistent as possible we used real people who we identified as having "low", "medium" and "high" risk profiles in an attempt to make sure they answered the different questions in each tool in the same way.  I was the "high" risk client.  I know some of the tools don't exist any more (some of the companies don't either) and this is not in any way knocking the validity of any tool (in case any providers read this) but it does highlight the issue.

The images below summarise the asset allocations from each tool with red indicating a significant difference from other tools.

Low Risk

Low

Medium Risk

Medium

High Risk

High

The range in allocations to various asset classes or sectors was quite extreme.  In the "high risk" profile the amount allocated to overseas equity ranged from 15% to 90% - that's pretty big to me.  Now I am not qualified to say which is right or wrong or even if there is a right or wrong answer but this post sets out what I saw and still see as being the issue - the tool you choose to use could have a big impact on the outcome for your clients so choose wisely.  In addition, if you can't pull that tool apart and see exactly how it comes up with the answers, what assumptions it uses, where the data comes from etc, should you really be using it?

That sets the scene and in the next post I will share the results of our survey on which tools are being used by advisers.  Please feel free to comment below.

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