Paul Resnik, co-founder of FinaMetrica, reveals the most common risk profiling mistakes (and explains how to avoid them).
Investment suitability is the foundation upon which good investment advice is built. Not only must the investment be suitable with regard to the investor’s goals, but also with regard to their risk capacity and risk tolerance.
As the Financial Services Authority (FSA) outlined in its guidance consultation on replacement business and CIPs recently, risk profiling provides a proven methodology to ensure the suitability of investment advice.
It requires sound processes and robust tools (which are now readily available) and advisory skills.
Fifteen common risk profiling mistakes (and how to avoid them)
Getting investment suitability right is therefore a blend of art and science.
The science lies in the tools the adviser uses. The art lies in the adviser’s ability to use the tools effectively, to work collaboratively with clients to obtain an in-depth understanding of their needs, to assist clients in resolving mismatches by identifying and explaining alternatives, and to guide the decision-making process.
Standards are raised through a combination of pull and push.
The pull comes from the example set by those professional advisers who continually seek best practices.
The push comes from regulators – and in the case of the UK, the regulator is setting the pace for the rest of the world.
Risk profiling mistakes
Unfortunately, risk profiling mistakes are widespread. These mistakes will not necessarily result in bad advice, but when they do, they are likely to lead to unhappiness for both adviser and client.
With regard to assessing risk required, the following mistakes are common:
- Projections use historical data blindly rather than forward-looking expected returns;
- Unrealistically optimistic assumptions are made about expected rates of return;
- Insufficient allowance is made for possible increases in expenses, particularly health and long-term care expenses;
- Insufficient allowance is made for longevity, particularly the likelihood of their clients living (significantly) longer than life expectancy;
- Portfolios are not rebalanced, so that over time the risk/return of the portfolio drifts away from the risk/return required; and
- The adviser has too few choices with regard to asset allocations or they are too widely spaced.
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