Investor Risk Profiling

7/27/2019 Investor Risk Profiling

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For investment proessionals only not or retail investors. The value o

investments, and the income rom them, may all or rise and investors may get

back less than they invested.

Investment risk and inancial advice

A guide to using Vanguards risk proling tool as a startingpoint to discovering a clients true risk prole.


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Contents

4 What is risk?

8 Adviser as alpha

12 The FSA and proling client risk

14 Clients true risk prole and asset allocation18 Starting conversations by measuring willingness

22 Behavioural aspects o risk attitude

31 Reerences and urther reading


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What is risk?

Your clients perception o risk and what the investment industry

portrays as risk can dier radically. This can lead to challenges or

advisers i they rely solely on quantitative measures o risk, such as

volatility or example.

Experience in markets where ee-based advice models are well

established, suggests that advisers should consider taking a more

comprehensive approach to educating their clients about the nature

o investment risk, as well as understanding their clients true and

complete risk prole.


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5What is risk?

Risk is not a single number

Technically-speaking, risk means the

possibility o a number o dierentoutcomes resulting rom a given action.

For example, beore you fip the coin you

know the result could be heads, tails or land

on its edge. Ater you toss the coin, one

o the three outcomes will occur.

Investment academics usually identiy risk

as the volatility associated with the prices

and/or returns o investments. However, we

believe this approach is much too narrow

or nancial advisers to use in their practice.

This is because clients do not think in terms

o narrow mathematical terms. Indeed,

clients oten think o risk as the prospect o

an undesirable outcome, such as a nancial

loss or not meeting an investment objective.

Risks your clients ace

Ination

Infation is like a stealth tax eating away atthe value o money. Clients may not see

a smaller cash balance in their accounts,

but they will denitely lose buying power.

In other words, the amount that they can

purchase with each pound in their pockets

slowly erodes over time.

Investors need to understand that some

savings vehicles ail to pay a return that

beats infation, especially ater tax is

deducted. So even i they reinvest every

penny o interest, the real purchasing power

o their savings could all.

Shortall

This means the risk o ailing to meet a long-

term investment goal. This could occur i an

investor didnt take on enough risk to get

the potentially higher rewards. On the other

hand, they could also be exposed to shortall

risk i they invest in too many high-risk

assets causing their portolio to lose value at

the wrong time.


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What is risk?6

A key eature o these risks is the apparent

inability o even the most skilled economists

and political scientists to predict them. You,

as the adviser, have a key role in explainingthat these risks are unpredictable and in

structuring portolios in such a way as to help

manage the impact these risks can have.

Broad market

Individual markets, whether equities, bonds

or even cash, are exposed to a variety o

actors that can lead whole markets, or even

most markets, to decline together. We have

seen this over the last decade, most markedly

during the recent global nancial crisis.

The relationship between risks and rewards

needs careul explanation to ensure that

investors understand how you are

structuring their portolios through time.The myriad o risks that can aect a clients

investment portolio can be daunting. But

shortall risk together with infation risk

highlight the need to invest to meet

long-term goals.

Economic/political

Economic and political actors play an

important role in the perormance o

investment markets. Economic actors

include economic growth, infation,

employment, interest rates and business

sentiment. Political risk includes changes

in government, political uncertainty and

international conficts.


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7What is risk?

Asset-based risks

There are also a number o potential risks associated with individual assets or asset classes

that investors need to consider.

Country The risk that domestic events such as political upheaval, nancial troubles, or natural

disasters will weaken a countrys nancial markets.

Credit The possibility that a bond issuer will ail to repay interest and capital on time. Funds that

invest in bonds are exposed to credit risk.

Currency The risk that changes in currency exchange rates cause the value o an investment to decline.

Interest The possibility that the prices o bonds will all i interest rates rise.

Liquidity The chance that an investment will be dicult to buy or sell.

Manager The chance that an investment will underperorm due to poor investment decisions by the

investment manager.

Sector The risk that a particular sector within a market, such as the oil and gas sector, or the travel

sector, may decline in value. For example, i oil prices surge, the oil and gas sector might rise,

but the travel sector might all due to rising uel costs.

Volatility Dierent types o investments fuctuate in value over time. This is reerred to as volatility

and is oten used by the investment industry to assess the potential risk associated with

an investment.

Security The risk that a specic share, bond or und youve invested in perorms badly.

Risk and your service promise

Explaining the various risks to clients helps

them to gain a better understanding o

the risk they take by investing. For the

adviser, it can also help detach the servicepromise they make to their client rom

the actual perormance o the investments

they recommend. Ater all, advisers do

not have any control over the perormance

o markets and making perormance

promises, actual or implicit, runs the risk o

leading to disappointment or the client and

disaection with the adviser.

See the next section or a uller description

o this process.


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Adviser as alpha

The data shows that picking investments that consistently outperorm

the broad market has historically been very dicult. This can lead to

disaection on the part o clients when investment results are not what

they eel they have been promised, even i you didnt explicitly promise

them anything.

The experience o successul ee-based advice practices in the UK

and abroad suggests advisers may be better served by changing their

perormance benchmark rom the markets return to the returns that

investors might achieve without your help.

A nancial adviser has a greater probability o adding value, i.e. alpha,

through relationship-oriented services, such as providing wealth

management, nancial planning and acting as their clients behavioural

coach, than by attempting to outperorm the market.


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9Adviser as alpha

Financial advice and RDR

With the end o commission, the nancial

advice market will complete its ongoingshit rom transaction-oriented sales to ee-

based advice.

From the clients perspective, ee-based

advice largely removes concerns about

potential conficts o interest in an advisers

recommendations. From the advisers

perspective, ee-based compensation can

promote stronger client relationships and

more reliable income streams. The adviser

can spend more time with clients, knowing

that compensation does not depend on

whether or not a transaction occurs.

What do we mean by the adviser

as alpha?

For some clients, paying ees whether ornot a transaction occurs may seem like

money or nothing. The conusion can grow

i the adviser bases their value proposition

on an ability to deliver better returns or

the client. But better returns relative to

what? For many advisers and clients, the

answer would be better than the market.

However, a more pragmatic answer or

both parties might be better than investors

would likely do i they didnt work with a

proessional adviser.

In this ramework, advisers demonstrate

their alpha by their ability to eectively act

as a wealth manager, nancial planner and

behavioural coach providing discipline and

logic to clients who are oten undisciplined

and emotional than by eorts to beat

the market.


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Adviser as alpha10

Historical studies o mutual und cash

fows show that ater protracted periods

o relative outperormance in one area o

the market, sizeable cash fows tend toollow. This perormance-chasing behaviour

can seriously harm a clients long-term

returns. The adviser as alpha target, then,

might be to improve upon this return

shortall by means that dont depend on

market outperormance: asset allocation,

rebalancing, tax-ecient investment

strategies and cash-fow management. It

can also mean, where appropriate, coaching

clients to change nothing at all i the clients

asset allocation model remains in line with

their risk prole and investment goals.

Proessional stewardship and

investor behaviour

Rather than investment capabilities,the adviser as alpha model relies on the

experience and stewardship that the adviser

can provide. Let alone, investors oten

make choices that impair their returns and

jeopardise their ability to und their long-

term objectives. Many are infuenced by

market perormance. This is oten evident in

market cash fows mirroring what appears

to be an emotional response ear or greed

rather than a rational one. Investors also

can be moved to act by und advertisements

that eature recent outperormance as i

the investor could somehow inherit those

historical returns despite disclaimers stating

that past perormance is no guarantee o

uture returns.


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11Adviser as alpha

For an insight into destructive investment

behaviour, with practical guidance on how

advisers can act as a behavioural coach,

please see our guide: Behavioural fnance

Behavioural inance

Understanding how the mind can help

or hinder investment success

By AlistairByrne

With Stephen P Utkus

For investment proessionals only not or retail investors.

To gain some insight into how to dene

a compelling client promise one that

is not tied to investment perormance

and that clients explicitly understand and

are willing to pay you to keep see our

guide Making a compelling client promise.


Deining a compelling client promise

Building a successul ee-based advice practice

The Financial Services Authority

guidance

But just as risk is not a single number, sotoo is a clients risk prole not a single

number or psychological dimension that can

be easily measured. The FSA recognised

this and issued new guidance on assessing

client suitability. The next section explores

the FSAs guidance on assessing investment

suitability.

For more inormation on building a robust

and systematic investment advice process,

please see our guide: Building a robust

investment advice process.


Building a robust investment advice process

Create business value Manage regulatory risk Delight your clients



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The FSA and proling

client risk

The FSA has studied the way client risk tolerance has traditionally beenproled by the industry and ound it wanting. As a result, it issued new

guidance consultation in January 2011: Assessing suitability: Establishing

the risk a customer is willing and able to take and making a suitable

investment selection. Any consideration o risk or risk proling must

take careul account o the FSAs ndings and guidance. The guidance

provides sobering reading or any adviser that has come to rely on

single-dimension measurements o risk proles.


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13The FSA and proling client risk

The consultation key ndings

The ollowing summary should not be considered as a substitute or reading the ull guidance

paper which can be ound on the FSA website.

Failure to collect and

properly account or all

the inormation relevant

to assessing the risk a

customer is willing and

able to take

Many rms ail to take account o a clients capacity or loss.

Many risk questionnaires rely on poor questions, scoring and

interpretations.

Failure to identiy customers that are unwilling to accept any risk o capital.

Relying on risk-profling

and asset-allocation tools

Failure to identiy limitations and faws in tools.

Need to mitigate limitations through suitability assessments and ull know

your customer processes.

Poor descriptions oattitudes to risk

Many descriptions not t or purpose.

Overly vague.

Do not eectively explain or dierentiate risk levels.

Failure to select suitable

investments or the

customer

Failure to match asset allocation and/or investments to a correctly

assessed client risk prole.

Failure to take account o all aspects o a clients objectives and nancial

situation.

Inappropriate ocus on the

risk a customer is willing

to take

Failure to take account o client needs, objectives and circumstances

outside o willingness.

Failure to recognise that suitability is about more than a clients attitude

to risk.

Understanding products

and underlying assets

Failure to understand the nature o the risks associated with assets

selected or clients.

Responsibilities when

using tools

Suggestion that rms do not appear to understand the tools they use.

Firms remain responsible or assessing suitability, even when using tools.

Tool providers need to provide clear supporting inormation to rms that

will use the tools to help rms use them as designed.

The FSAs timely ndings and guidance has inormed every step o the development o our

tool or measuring investor risk proles and the process we advocate or using it. Wevewritten this guide, in part, to help advisers address the FSAs concerns.

You will also nd some helpul checklists and tools at the end o this guide, designed to help

you structure your approach to applying the regulators guidance in your business.


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Clients true risk prole

and asset allocation

In the past, some advisers might have stopped with a clientswillingness to take risk as measured by an attitude to risk tool, and

proceeded directly to selecting investments. However, in light o RDR

and increasing regulator scrutiny, the results o such a tool should only

provide a starting pointor a conversation about investment risk, not

an ending. It should not be thought o as a substitute or a suitability test

But what is the most appropriate way to develop a clients risk prole,especially in light o the FSA guidance?


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15Clients true risk prole and asset allocation

Starting conversations

Asking your client to complete a risk proling

questionnaire should mark the beginning oa conversation with them about risk. You

can use the generalised output to move the

conversation onto deep and critical issues

in the know your client process. Only by

having a thorough and careully structured

conversation, as part o a systematic

approach to investment advice, can advisers

understand a given clients true investment

risk prole.

Our experience in other ee-based advice

markets suggests that this is where advisers

can add real value or clients.

Willingness is just the beginning

A clients willingness to take risk, as

measured by a questionnaire or example,is only a small part o a clients ull and true

risk prole.

Willingness Ability

Need

Trueclient risk

prole

Three key components comprise an

individuals true risk prole:

Psychological willingness to take risk,

sometimes called risk attitude

Financial ability to take risk, or risk

capacity

Need to take risk, including the need to

accept risk to meet an objective, avoid

alling short o a goal or having wealth

eroded by infation.


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Clients true risk prole and asset allocation16

Contradictions in the risk prole

Clients psychological willingness to take

risk can sometimes clash with their nancialability to do so. For example, i someone

has a high risk tolerance, but has a nely

balanced nancial situation. When such a

confict exists, nancial advisers need to

take time to counsel the client and explain

the consequences o the mismatch. Youll

need to explain the consequences o low

or negative returns to more aggressive

investors with less liquid wealth.

Ultimately, a client might insist on an

investment strategy that matches their risk

attitude and the adviser may need to accept

this. But having had the conversation, the

client/adviser decision will at least be in

the context o a thorough review o the

investors risk capacity, attitude and need.

Ability to take risk relates to nancial

circumstances and investment goals.

Generally speaking, the higher the level o

wealth relative to liabilities, and the longerthe investment horizon, then the greater the

ability to take risk. The nancial planning

process should consider all o these issues

careully.

Willingness, or risk attitude, on the other

hand, relates to psychology, rather than to

nancial circumstances. Some individuals

nd the prospect o investment volatility and

the chance o losses distressing. Others are

more relaxed about those issues. Financial

advisers should try to ully understand the

psychological willingness o each client

to take risk. This is what risk proling

questionnaires ocus on.

The need to take risk is the third component

o a true client risk profe. Willingness and

ability need to be evaluated in the context o

an individuals need to take risk to achieve a

goal. I they have a very low risk prole with

a very demanding investment objective,

something will have to give.


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17Clients true risk prole and asset allocation

The investment objectives and the

client risk prole

People can sometimes have dierent riskproles with dierent pools o assets. They

might be willing to take on considerable risk

with assets they earmark or a particular

goal, but not with others. The simplest

way to think o this is to think o the 5

some people spend each week on lottery

tickets. Theyre willing to take the highest

risk possible with that 5, but not with the

money they set aside or their childrens

education.

While this kind o separation might not make

sense rom a purely nancial theory point

o view, many investors rely on separate

mental accounts when thinking about

their investments. For more inormation on

mental accounting please see our guide:

Behavioural Finance Understanding how

the mind can help or hinder investment

success.

Dierent risk proles in couples

Sometimes couples that deal with their

investments together have conficting riskattitudes. In this case, youll need to explain

the consequences o dierent strategies and

approaches. It may be possible to negotiate

a compromise position ater explaining the

issues, but in some cases the views o one

spouse will prevail.

Later in this guide youll nd a section on

having this conversation with your clients,

including a helpul checklist and other

practical tools.


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Starting conversations by

measuring willingness

Having established that a clients willingness to take risk is just thebeginning o a client conversation about risk, we can ocus on how to

best measure that willingness.

You can measure risk attitude in a variety o ways, each with its

own advantages and disadvantages. Best practice suggests using a

structured interview or a questionnaire to help draw out the issues.


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19Starting conversations by measuring willingness

Measuring willingness the

Vanguard approach

Risk attitude is a complex area and as aresult risk proling is not an exact science.

Nonetheless, a well-designed risk proling

tool can still make an important contribution

to the nancial planning process.

Vanguards online risk attitude proling tool

or UK advisers is based on the Byrne-Blake

Attitude to Risk Questionnaire. The Byrne-

Blake approach to risk proling builds on

established psychometric principles and

represents best practice rom the science

o measuring an individuals willingness to

take risk.

The questionnaire has been designed or

ease o use by a variety o dierent client

types. It avoids questions that present

complex investment scenarios, require

mathematical calculations or use concepts

such as percentages. We also sought to

avoid vague questions, or those that deal

with issues that people outside the industry

might not know anything about.

How the tool works

The tool uses a series o short statements

ollowed by a scale where the individualcan indicate whether they agree or not with

a statement. The scale, known as a Likert

Scale, typically includes:

Strongly Agree

Agree

No Strong Opinion

Disagree

Strongly Disagree

The questionnaire has 12 questions, making

it relatively ast and easy to complete. It

typically takes less than six minutes. The

tool uses a ve-point scale as more choices

could make the questions too complicated.


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Starting conversations by measuring willingness20

Questions with any o the ollowing

characteristics were culled rom the

question bank.

Questions the test group ound dicultor irrelevant.

Questions that ailed to accurately predict

a given characteristic or dierentiate

among individuals (See or example,

Grable and Lytton, 2003).

Statistically outlier questions that

werent closely correlated (less than 0.30)

compared to the overall index score.

Normalising the questions

The nal questionnaire needed to be long

enough to produce reliable results, while

short enough to be used in the nancial

planning process. A baseline or norm was

then established or the questionnaire in

order to map respondents to broad risk

categories.

To establish a norm group or the

short questionnaire, Byrne and Blake

commissioned market research rm YouGov

to conduct an online survey with a sample

representative o the British population. The

results o this study allowed a comparison o

each individuals response to the distributiono responses across the population. This

allowed the testing o the reliability o a

questionnaire using the pilot study.

Writing the questions

Byrne and Blake identied the various

components that make up an individualsrisk attitude and wrote questions to address

each component. Following best practice,

each question contains only one question or

statement and avoids subjective words like

requency whenever possible.

Testing the questions or

suitability

All o the questions have passed suitability

screening by a test group. 141 individuals

completed the initial online test.

The initial test group had the ollowing

characteristics:

65% male; 35% emale

Average age o 35 years

Ages ranged rom 19 to 70 years, with a

standard deviation o 11 years


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21Starting conversations by measuring willingness

Answers to questions are scored rom

0-4, depending on whether the question

uses standard or reverse wording. This

means that the raw scores or the shortquestionnaire range rom 0 to 48.

When reporting the test scores, the scores

were normalised by subtracting the mean

score and dividing by the standard deviation.

In order to improve the clarity o the score,

the reported scores were urther adjusted

so that an average response gets a score o

50 and the distribution o reported scores

has a standard deviation o 10. This ts more

readily with peoples perceptions o where

their score should all on a scale o 0-100.

The adjusted scores are then used to map

individuals to broad risk attitude categories

(see the ollowing section or descriptions o

these categories).


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Behavioural aspects o

risk attitude

The complexities o measuring investment risk attitude require that thequestionnaire address a number o interrelated actors. Vanguards tool

addresses our identied behavioural actors o risk.


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23Behavioural aspects o risk attitude

Knowledge

Individuals with more nancial and

investment knowledge are generallymore willing to accept investment risk.

Knowledgeable individuals oten know

that they will need to take at least some

risk to generate higher returns. Short-term

fuctuations in the values o investments

need not matter or investors with longer-

term horizons.

Comort with risk

Some individuals have psychological traits

that allow them to accept taking risk. These

individuals typically see risk as involving

a thrill or opportunity rather than as a

danger or a loss. Questions addressing

risk comort levels oten involve individuals

choosing among alternative courses o

action relating to saving decisions, or simply

stating their comort level with risk.

Investment choice

Preerences or dierent kinds o

investments can also help to gauge risk

attitude, or example, the saety o a bank

account versus the risk/return potential othe stockmarket. However, questions o this

nature need to avoid using nancial jargon

to ensure that clients truly understand the

questions asked.

Regret

This negative emotion arises rom making

the wrong decision. Individuals who areparticularly prone to regret tend to try to

make decisions that are less likely to cause

it. For example, they might engage in regret

avoidance.

The allocation o questions across the

various categories:

Risk attitude aspect Number o questionsin questionnaire

Knowledge 2

Comort with risk 3

Investment choice 6

Regret 1

Total 12

For a straightorward guide to some

behavioural traits related to investing

and risk, along with the consequences

or advisers, see our guide: Behavioural

nance Understanding how the mind

can help or hinder investment success. Itsavailable ree or proessional investors on

the Financial adviser section o our website

Vanguard.co.uk.


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Behavioural aspects o risk attitude24

Pre-screening: short, medium and

long term

The length o an investment time horizoncan change the types o investments an

adviser should consider or a given client.

For that reason, our tool takes this into

account when scoring the questionnaire, or

deciding i investing bonds and/or equities is

even appropriate.

Our questionnaire then asks: How long do

you intend to invest beore you need your

money?

I a respondent answers less than three

years to this question, the tool stops

there, deaulting to what is, in eect, a

savings only position.

I a respondent answers between three

and ten years, the tool deaults to a

medium term (3-10 years) algorithm to

score the questionnaire

I a respondent answers more than

ten years, the tool deaults to a long

term (10+ years) algorithm to score the

questionnaire.

The tool includes a variety o underlying

algorithms and calculations to arrive at a

generalised risk category with which to

start a client conversation. Beore movingon to the twelve questions that comprise

the questionnaire, the tool pre-screens

respondents to nd out i they should even

be considering investing at all, based on a

no risk attitude, or too short a time horizon.

Pre-screening: saving vs. investing

Vanguard believes that anyone who is

unwilling to take any risk with their capital

should not consider investing in anything

other than the saest savings vehicles. For

that reason, our questionnaire asks:

Are you prepared to take the chance

o losing some o your investment in

seeking income or growth rom your

investment portolio?

I a respondent answers No to this

question, the tool stops there, deaulting to

what is, in eect, a savings only position.

Advisers would need to make them aware

o the ull ramications o their cautious

attitude, in terms o the long-term value o

their savings vs. the eect o infation.

Scoring the questionnaire


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Risk proling questions

People who know me would describe me

as a cautious person. I eel comortable about investing in the

stock market.

I generally look or the saest type o

investment, even i that means lower

returns.

Usually it takes me a long time to make up

my mind on nancial matters.

I associate the word risk with the idea o

opportunity.

I preer the saety o keeping my money in

the bank.

I nd investment and other nancial

matters easy to understand.

I am willing to take substantial nancial

risk to earn substantial returns.

I have little experience o investing in

stocks and shares.

When it comes to investing, Id rather be

sae than sorry.

Id rather take my chances with high risk

/ high return investments than have to

increase the amount I am saving.

I am concerned by the uncertainty o

stock market investment.

Twelve risk prole questions

Each question uses a ve-point scale

ranging rom Strongly Agree through toStrongly Disagree.

The questionnaire includes a blend o

normal questions, where agreement

indicates an inclination to take risk and

reverse questions where agreement

indicates aversion to risk. The proling

tool compiles the score by weighting the

answers equally, taking account o whether

they are normal or reverse questions.

Question

response

Score or

normal

questions

Score or

reverse

questions

Strongly agree 4 0

Agree 3 1

No strong opinion 2 2

Disagree 1 3

Strongly disagree 0 4


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Sense checks

The scoring o the tool also includes

sense checks along the way to account orcontradictions in a respondents answers.

For example, someone may answer nearly

all o the questions in such a way that

indicates high comort with risk taking

such that the tool puts them into the high

category. However, theyve indicated that

they strongly disagree with the statement:

I eel comortable about investing in the

stock market. The output would highlight

this apparent contradiction so their nancial

adviser could delve urther into the topic

with them as part o the conversation that

could lead to a ull understanding o their

true risk prole.

Generating output

Based on time horizon indicated in the

second question, and the Byrne-Blakeproprietary algorithm, the score will be

calculated to output a generalised risk prole

broken into ve labels. See descriptions on

ollowing page

Low

Low mid

Mid

Mid high

High


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Low-mid risk investors with time horizons o

ten or more years typically have portolios

with a majority o bonds and cash, but with

some exposure to equities and other higherrisk investments.

Mid risk

In general, mid risk investors understand

that they have to take investment risk to

meet their long-term goals. Theyre oten

more willing to take risk with at least part

o their available assets. Mid-risk investors

may have some experience o investment,

including investing in products containing

higher risk assets such as equities and

bonds. They can usually make up their

minds on nancial matters relatively quickly,

but they still suer rom some eelings o

regret when their decisions turn out badly.

Mid risk investors with time horizons o ten

years or more typically have portolios with

a mix o higher risk investments such as

equities and lower risk investments such as

bonds and cash.

Low risk

In general, low risk investors preer knowing

that their capital is sae and theyre notcomortable investing in equities. They

would rather keep their money in the bank.

Low risk investors are unlikely to have

much experience o investment beyond

bank accounts. They will usually suer rom

severe regret i their decisions turn out badly.

Low risk investors with time horizons o

ten years or more typically have portolios

with a majority o bonds and cash, with

little exposure to equities or other higher

risk investments. Low risk investors need

to understand that their caution can mean

that their investments may not keep pace

with infation, or that may all short o their

investment goal.

Low-mid riskIn general, low-mid risk investors would

preer not to take risk with their investments,

but they can be persuaded to do so to a

limited extent. They would preer to keep

their money in the bank, but they may realise

that other investments might be better over

longer term. Low-mid risk investors may

have some limited experience o investmentproducts, but will be more amiliar with bank

accounts than other types o investments.

Low-mid risk investors can oten suer regret

when decisions turn out badly.

Description o investor risk appetites


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High Risk

In general, high risk investors want the

highest possible return on their capital andare willing to take considerable amounts o

risk to achieve this. Theyre usually willing

to take risk with all o their available assets.

High risk investors typically have substantial

amounts o investment experience and will

typically have been managing their own

investments. High risk investors have rm

investment views and will make up their

minds on nancial matters quickly. They do

not suer rom regret to any great extent

and can accept occasional poor outcomes

without much diculty. High risk investors

with time horizons o ten years or more

typically have portolios made up primarily

o higher risk investments such as equities,

with little in bonds and cash.

Mid-high Risk

In general, mid-high risk investors are willing

to take on investment risk and understandthe nature o the long-term risk/return trade

o. Theyre willing to take risk with most o

their available assets. Mid-high risk investors

are typically experienced investors, who

have used a range o investment products in

the past. Mid-high risk investors will usually

be able to make up their minds on nancial

matters quite quickly. While they can suer

rom regret when their decisions turn out

badly, they can accept that occasional poor

outcomes are a necessary part o long-term

investment. Mid-high risk investors with

time horizons o ten years or more typically

have portolios with a majority o higher risk

investments such as equities, but that also

contain bonds and cash.

Note: These profle descriptions are only illustrative. While they outline

the common traits o individuals with the relevant risk profle scores, every

individual is dierent and their scores will be built up rom dierent

combinations o responses to the questions in the risk attitude profling

questionnaire. The results should support and enhance, not replace, the knowyour client process. Financial advisers should use this to start a discussion

about investment risk with the investor.


29/36


Checklist: Using third-party risk

proling tools

Again, with the FSA guidance in mind, yourrisk proling tool should:

Support regulation and refect FSA

guidance

Describe its scope and any limitations

Explain its provenance and structure

Identiy clients with no-risk proles

Be written in client riendly language

Include an audit trail acility

Be simple and easy to use

Checklist: Selecting investments

Implement a robust investment process

Research on investment undamentals

Match appropriate product to risk

willingness, ability and need

Measure risk using more than just

volatility

Consider graded unds to cover risk range

Ensure unds have clear and descriptive

(not potentially misleading, e.g. cautious)

names

Look or complete transparency o und

components

We have created a number o tools and

checklists to help you assess risk with your

clients, understand their true risk prole

and help you to comply with the FSArequirements.

Checklist: Establishing a clients

willingness or risk

Based on the FSA guidance, the process

used to establish a clients willingness to take

risk should:

Help you to ully understand the clients

capacity or loss

Help you ully understand their capacity

or risk

Include clear and understandable questions

Highlight conficting responses

Use dierentiated and well described

risk categories

Include supporting charts o the variance

o possibilities

Have the ability to record alternative advice

Tools and checklists


30/36


We have also created a guide designed to

help you discuss investment risk with your

clients. It discusses investment risk and

potential reward in a short, straightorwardand client-riendly manner. You can

download the guide rom our website, or

order printed copies rom Adviser Support.

Client tools

Visit the Practice management section

o our Adviser website or a series oworksheets to use with your clients,

including:

Financial satisaction survey

Lie goals prole

Lie transitions prole

Simplied personal balance sheet

Simplied personal cash fow statement

Financial lie history

Lie principles

Guidance or how to use these sheets can

be ound in our extensive guide Building

a robust investment advice process.


Building a robust investment advice process

Create business value Manage regulatory risk Delight your clients


Investment risk

Balancing investment risk and potential reward


31/36

31Reerences and urther reading

Cordell D. (2002) Risk tolerance in two

dimensions Journal o Financial Planning,

May 2002.

Grable J. and Joo S. (2000) A cross-

disciplinary examination o nancial risk

tolerance Consumer Interests Annual46.

Grable J. and Lytton R. (1999) Financial

risk tolerance revisited: the development

o a risk assessment instrument Financial

Services Review8, 163-181.

Hanna S., Gutter M. and Fan J. (2001)

A measure o risk tolerance based on

economic theory Financial Counselling and

Planning, 12:2, 53-60.

Kline P. (1993) The Handbook o

Psychological TestingLondon: Routledge.

Loomes G. and Sugden R. (1982) Regret

theory: an alternative theory o decision

under uncertainty Economic Journal92,

805-824.

Maginn J., Tuttle D., McLeavey D., Pinto J.

(2005) The portolio management process

and the investment policy statement in

Managing Investment Portolios: A DynamicProcessedited by J. Maginn and D. Tuttle.

Charlottesville VA: CFA Institute.

For a good overview o nancial risk

tolerance, risk attitude and risk proling, we

recommend starting with Grable and Lytton

(1999) and Roszkowski et al. (2005).

For an in-depth description o psychometric

analysis and test design, we recommend

Kline (1993) and Rust and Golombok (1989).

See below or ull reerences

Reerences cited:

Bailey J. and Kinerson C. (2005) Regret

avoidance and risk tolerance Financial

Counselling and Planning16:1, 23-28.

Barber B. and Odean T. (1999) The courage

o misguided convictions: The trading

behaviour o individual investors Financial

Analysts Journal, November.

Callan V. and Johnson M. (2002) Some

guidelines or nancial planners on

measuring and advising clients about their

levels o risk tolerance Journal o Personal

Finance1:1, 31-44.

Carducci B. and Wong A. (1998) Type A

and risk taking in everyday money matters.Journal o Business and Psychology, 12,

355-359.

Reerences and urther reading

Reerences and urther

reading


32/36

32 Reerences and urther reading

Roszkowski M., Davey G. and Grable J.

(2005) Insights rom psychology and

psychometrics on measuring risk tolerance

Journal o Financial Planning, April.

Roszkowski M., Delaney M., and Cordell D.

(2004) The comparability o husbands and

wives on nancial risk tolerance Journal o

Personal Finance3:3, 129-144.

Rust J. and Golombok S. (1989) Modern

PsychometricsLondon: Routledge.

Sherin H. and Statman M. (1985) The

disposition to sell winners too early and rise

losers too long: theory and evidence Journal

o Finance40:3, 777-790.

Snelbecker G., Roszkowski M. and Cutler

N. (1990) Investors risk tolerance and

return aspirations, and nancial advisers

interpretations: a conceptual model and

explanatory data Journal o Behavioural

Economics19:4, 377-393.


33/36

33Reerences and urther reading

Alistair Byrne

Principal, Investit. Alistair earned a PhD in

nance rom the University o Strathclyde

and is a CFA charterholder. His research has

been published in a number o academic and

proessional journals, including the Financial

Analysts Journal. He is also a visiting ellow

at the Pensions Institute at Cass Business

School.

David Blake

Dr David Blake is Proessor o Pension

Economics at Cass Business School, City

University, Director o the Pensions Institute

and Chairman o Square Mile Consultants, a

training and research consultancy. Throughout

his career, he has held a number o academic,

consulting and research positions. In 1996, he

established the Pensions Institute

(www.pensions-institute.org).


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Important inormation

This document is directed at investment prof essionals in the UK only and should not be distributed to, or relied upon by retail investors.Th i l i d i hi d i b d d b ll h li i i b ll i i i

Connect with Vanguard > vanguard.co.uk > Adviser Support 0800 917 5508

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Investor Risk Profiling

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