Investment Risk Profiling PDF

Investment Risk Profiling Simplifying the Process Table 2 provides a scoring sheet that can be used to evaluate the behavioral loss tolerance elements described in this report and to derive an investor’s behavioral loss tolerance score. TABLE 2.  BEHAVIORAL LOSS TOLERANCE SCORING SHEET What is the...

Investment Risk Profiling Simplifying the Process Table 2 provides a scoring sheet that can be used to evaluate the behavioral loss tolerance elements described in this report and to derive an investor’s behavioral loss tolerance score. TABLE 2.  BEHAVIORAL LOSS TOLERANCE SCORING SHEET What is the investor’s risk tolerance or willingness to take financial risk? SCORE Very Low Low Moderate High Very High 1 2 3 4 5 What is the investor’s preference when holding risky assets? Maximize Safety Mostly Safety Mix of Safety and Return Mostly Return Maximize Return 1 2 3 4 5 How knowledgeable is the investor about financial and investment concepts? Not at All Knowledgeable Minimally Knowledgeable Moderately Knowledgeable Competent Very Knowledgeable 1 2 3 4 5 How much experience does the investor have with investment products? None Very Little Some Modest Extensive 1 2 3 4 5 What is the investor’s perception of the riskiness of the stock market? Very Risky Somewhat Risky Neutral Somewhat Safe Very Safe 1 2 3 4 5 In the past, when faced with investment losses, what action did the investor take? Sold Investment Did Nothing Purchased More 1 3 5 TOTAL Scores for each of the elements comprising the behavioral loss tolerance factor should be summed. The total scores possible for the factor range from a low of 6 to a high of 30. Scores should then be matched to the following behavioral loss tolerance categories: • • • LOW = 6 to 13 MODERATE = 14 to 22 HIGH = 23 to 30 CFA Institute | 11 Investment Risk Profiling RECONCILING AND RELATING THE IRP TO A PORTFOLIO STRATEGY Once the three factors of risk need, risk-taking ability, and behavioral loss tolerance have been assessed independently, the financial advisor can develop an IRP that will inform portfolio recommendations. The IRP is not only a qualitative assessment of an investor’s financial and emotional aptitude for engaging in transactions that involve risk but also a quantitative assessment of an investor’s need for risk (usually expressed as a required RoR to achieve goals) and risk-taking ability (typically considered in the context of drawdowns or volatility and related to the effect on an investor’s standard of living). • EXAMPLE Risk Need RiskTaking Ability Behavioral Loss Tolerance Low High Low • The IRP may reveal conflicting factors that require an advisor’s professional judgment to reconcile. The following decision rules can be used to guide the interpretation of an IRP: • The investor’s risk need cannot exceed the investor’s risk-taking ability associated with the goal. Reconciling these two factors requires that a financial advisor counsel the investor to reconsider goals and/or savings rates. Higher risk-taking ability can be discounted when both the risk need and behavioral loss tolerance are lower. RiskTaking Ability Behavioral Loss Tolerance Portfolio Strategy High Low High Reconsider Goals • A lower risk need can be discounted when both risk-taking ability and behavioral loss tolerance are higher. EXAMPLE Risk Need RiskTaking Ability Behavioral Loss Tolerance Low High High 12 | CFA Institute Portfolio Strategy Consistent with Risk-Taking Ability and Behavioral Loss Tolerance Consistent with Risk Need and Behavioral Loss Tolerance Higher behavioral loss tolerance can be ignored when both the risk need and risk-taking ability are lower; the advisor may need to coach the client to overcome her behavioral tendencies to take risk in light of the realities of the client’s risk need and risk-taking ability. EXAMPLE Risk Need RiskTaking Ability Behavioral Loss Tolerance Low Low High EXAMPLE Risk Need Portfolio Strategy • Portfolio Strategy Consistent with Risk Need and Risk-Taking Ability Low behavioral loss tolerance can never be ignored; however, a financial advisor may conclude that appropriate client counseling and education can be used to “nudge” an investor into a higherrisk portfolio when the risk need and risk-taking ability are higher. EXAMPLE Risk Need RiskTaking Ability Behavioral Loss Tolerance High High Low Portfolio Strategy Counseling and Education Investment Risk Profiling • A financial advisor should not recommend a portfolio allocation that exceeds an investor’s risk-taking ability. Risk-taking ability sets an upper volatility bound to a portfolio recommendation. Because risk-taking ability changes (especially as the goal time horizon shortens), this factor must be reassessed regularly. EXAMPLE Risk Need RiskTaking Ability Behavioral Loss Tolerance Low Low High Portfolio Strategy Consistent with Risk-Taking Ability Portfolio Implications of IRP Categorizations Throughout this report, documentation has been made indicating where financial advisors may simplify the process by categorizing elements of the three factors that make up an IRP. These categorizations may be used to guide some financial advisors to appropriate portfolio recommendations. A process for categorization based on the IRP development process described in this report is presented in Appendix D. SUMMARY The current standard of practice of using a single risk coefficient or data input as a guide to an appropriate portfolio choice (either within the context of modern portfolio theory or as a tool to select an advisordeveloped portfolio) is likely flawed. Stated another way, a single score derived from a risk-tolerance questionnaire or revealed preference test, while useful in describing a broader risk profile, is not sufficient to describe an investor’s risk need, risk-taking ability, or behavioral loss tolerance. Regardless of the approach used to develop portfolio selection recommendations, financial advisors face the real risk of failing to meet an investor’s goal(s) if a selected portfolio is positioned either too conservatively or too aggressively. To increase the likelihood of achieving investor goals, financial advisors must use tools that fully inform professional judgment when making portfolio allocation recommendations. The risk-profiling modelling process this report describes helps move risk profiling away from the measurement of one or a few data points while standardizing some of the elements and decision points in the risk-profiling process. CFA Institute | 13 Investment Risk Profiling APPENDIX A coefficient). Asking a questionnaire or test developer for evidence of criterion validity before adopting a tool is appropriate. Two types of criterion validity are particularly important: • Concurrent validity provides evidence that the questionnaire or test score is associated with other measures of financial risk taking. ■ For example, a financial risk-tolerance score should be positively associated with holding equities and negatively associated with holding cash and cash equivalent assets. • Predictive validity provides evidence that questionnaire or test scores provide meaningful insight into future behavior. ■ For example, scores should be predictive of who is more or less likely to react negatively during a bear market. Assessing and Choosing a Risk-Tolerance Measure18 The measurement of financial risk tolerance—an investor’s willingness to engage in financial behavior whose outcomes are unknown and potentially negative—is typically conducted using one of two tools: • • a psychologically derived questionnaire a revealed preference risk-aversion test Normally, financial advisors either use a commercial product or rely on a questionnaire developed in-house to asses an investor’s tolerance for financial risk and to meet regulatory requirements. Both approaches offer unique advantages and disadvantages in terms of accuracy, repeatability, and overall validity. When deciding on an approach—and selecting a particular risk-tolerance assessment tool—both the validity and reliability of the tool should be considered. Validity Validity refers to how accurate a tool is in describing or predicting human trait factors, attitudes, or behavior. Stated another way, “validity refers to how well the assessment tool actually measures the underlying outcome of interest” (p. 119),19 in this case, an investor’s willingness to take financial risk. For a questionnaire or test to be valid, scores must be accurate in forecasting how an investor will respond in real-life financial situations. Two forms of validity are especially important with respect to the choice of a financial risk-tolerance tool: • Content validity: This assessment of validity is based on the professional judgment of subject matter experts. The questions asked in the questionnaire or test should appear, to a professional, appropriate in terms of accurately assessing an investor’s willingness to take a financial risk. A measurement tool should also pass a financial advisor’s test of face validity, which is an advisor’s feeling that the questions asked appear correct. Criterion validity: This assessment of validity is measured using a statistical test (e.g., correlation • “Red flags” that a question or questionnaire might not be valid include the following: Questions elicit risk tolerance outside the context of investment risk taking. These types of questions do a poor job of predicting investment risk-taking behavior primarily because risk tolerance tends to be domain specific and not a generalized characteristic. The following is an example of a poor question: I enjoy risky activities such as skydiving, motorcycle riding, and rock climbing. • • • • • 1—Strongly Agree 2—Agree 3—Neutral 4—Disagree 5—Strongly Disagree Questions focus on having an investor anticipate future behavior. Investors are generally unable to accurately assess their own financial sophistication or future behavior, especially when asked during a market in which prices are generally increasing. These types of questions should be avoided in favor of more objective questions. The following is an example of a problematic question: The authors wish to thank Dr. Michael Roszkowski for his comments on elements of this appendix. Gail M. Sullivan, “A Primer on the Validity of Assessment Instruments,” Journal of Graduate Medical Education 3, no. 2 (June 2011): 119–120. 18 19 14 | CFA Institute Investment Risk Profiling If the stock market were to fall 30% over the next six months, which would you choose to do? • • • 1—Sell Immediately 2—Do Nothing 3—Buy More Questions pose 50/50 chance outcome choices. Investors are more likely to take a risk when the odds of success are known in advance; however, financial and investment outcomes are not known in advance, nor do typical investment choices have 50/50 predetermined odds. All revealed preference tests use a series of 50/50 outcome choice questions. These tests should be approached with caution because responses may not be valid. An example of a revealed preference question follows: Suppose that you are about to retire and have two choices for a pension. Annuity A gives you an income equal to your preretirement income. Annuity B has a 50% chance your income will be double your preretirement income and a 50% chance that your income will be 20% less than your preretirement income. Which annuity would you choose? Questions bias an investor. A common problematic question is one in which an illustration is provided showing how an investor should respond or how others (particularly experts or peers) most often respond. This type of question may bias an investor to respond with what she or he believes is the “correct” answer rather than how the investor truly feels. The following is an example of a biased question: Many financial experts recommend that the percentage of equity securities in your portfolio should be equal to 100 minus your age. What percentage of equity securities would you be comfortable investing? • 1—0–20% • 2—21–40% • 3—41–60% • 4—61–80% • 5—81–100% Questions imbed complex language or investment-specific verbiage. Words such as “risky,” “volatile,” “aggressive,” and “conservative” have different connotations in different contexts. Words, terms, and phrases should be well defined and understood within the context of a question, and words should exhibit a consistent magnitude for each scale response. Financial abbreviations and acronyms, even well-known ones, should be avoided. The following is an example of a complex language question: How would you describe your preferred investment strategy? • • • • • 1—Capital Preservation 2—Conservative 3—Balanced 4—Risky 5—Maximize ROI Questions are double-barreled. Questions should be framed to assess just one concept or issue because with “double-barreled” questions, the investor could both agree and disagree simultaneously, which then forces the investor into a guessing situation. The following is an example of a double-barreled question: Please agree or disagree with the following statement: I am financially knowledgeable and experienced. • • 1—Agree 2—Disagree Reliability Of equal importance when selecting a risk-tolerance assessment tool or questionnaire is documentation of reliability. Reliability refers to whether a tool or questionnaire generates the same results each time it is used in the same setting with the same person. For example, a person’s scored outcome should be similar in periods of market stress and market expansion. If a questionnaire or measurement tool is not reliable, the approach is, by definition, invalid. The measurement of reliability is based on a statistical test. Reliability is most often measured as internal consistency between and among items asked in a questionnaire. Questionnaires and scale developers commonly report reliability as Cronbach’s alpha.20 Traditional measures of reliability have been criticized as being inadequate. Alternatives to Cronbach’s alpha include omega and the greatest lower bound. See Gjalt-Jorn Ygram Peters, “The Alpha and the Omega of Scale Reliability and Validity: Why and How to Abandon Cronbach’s Alpha and the Route towards More Comprehensive Assessment of Scale Quality,” European Health Psychologist 16, no. 2 (April 2014): 56–69. 20 CFA Institute | 15 Investment Risk Profiling Another form of reliability is based on test-retest data. This estimate of alpha is derived by comparing a test taker’s score on the same questions from one period to that from another period. From a due diligence point of view, a questionnaire or test should exhibit a reliability score of 0.70 or higher. • Asking a risk-tolerance questionnaire developer to provide evidence of reliability is a best practice. Reliability will generally be reported as Cronbach’s alpha (a). Scores of a  0.70 indicate that the questionnaire is more likely to generate consistent, dependable, and meaningful results across time and across investors. A Note on Psychologically Derived Questionnaires Numerous firms provide risk-tolerance (risk-aversion) assessment platforms for use when assessing an investor’s willingness to take financial risk, and most are administered via a series of scale questions in which a single “score” is estimated. In the context of this report, a questionnaire that includes questions related to all six elements of the behavioral loss tolerance factor of the risk-profiling process would be beneficial.21 Unfortunately, few such questionnaires exist. Instead, those who use the risk-profiling process described in this report will need to choose a risktolerance questionnaire and supplement the derived score with data representing the other elements. When evaluating a particular risk-tolerance questionnaire or test, understanding the validity and reliability characteristics of the questionnaire or test, as has been described, is important. Another factor to consider is the length of the risk-tolerance assessment. How many questions a questionnaire or test should include is a matter of some dispute. Financial advisors and investors prefer fewer questions; however, researchers, in general, argue that asking more questions helps increase validity and reliability, making scores more accurate. As Michael Joseph Roszkowski explains,22 Only by presenting the investor with a sufficiently large number of questions can you hope to get a representative sample of past behaviors, current attitudes, and intentions regarding the future. The greater the number of questions asked, the more accurate the results of the assessment are likely to be. (p. 47) While the optimal number of questions is still a matter of preference, an appropriate range is between 7 and 30 items. Another problem observed in many risk-tolerance questionnaires is an attempt to blend subjective behavioral tolerance questions with objective questions relating to an investor’s need and ability to take risk. For a questionnaire to ask about time horizon, age, liquidity need, and risk capacity is common. Although each of these elements is crucial to developing an overall risk profile, subjective and objective elements should not be averaged together within a weighting methodology. This ad hoc commingling of subjective and objective questions can lead to an over- or underweighting of subjective behavioral factors relative to objective factors. Time horizon and risk capacity questions should generally not be included in a risk-tolerance questionnaire or test. Overall, the use of a psychometrically valid and reliable risk-tolerance questionnaire is the preferred method for measuring an investor’s risk tolerance—one of the six elements comprising an investor’s behavioral loss tolerance; however, financial advisors and regulators must be cognizant of the common theoretical problems observed in both commercial and in-house firm-developed questionnaires and be able to identify and discern the good tools from the bad. A Note on Measures of Revealed Preference As noted earlier in the text, two types of risktolerance assessments are widely used in practice: psychologically derived questionnaires and revealed preference risk-aversion tests. The evaluation of a revealed preference test requires additional due diligence. Although sometimes presented in questionnaire format, measures of revealed preference are generally not developed in the same manner as a psychologically derived scale. Tools based on psychological theory almost always combine responses across questions when calculating a score.23 Revealed preference measures, These elements are willingness to take financial risk, risk preference, financial knowledge, financial experience, risk perception, and risk composure (past behavior). 22 Michael Joseph Roszkowski, “How to Assess an Investor’s Financial Risk Tolerance: The Basics,” in Personal Finance Risk Tolerance (Bryn Mawr, PA: The American College, 1992). 23 This is sometimes referred to as a summated scale. 21 16 | CFA Institute Investment Risk Profiling FIGURE A1.  EXAMPLE OF REVEALED PREFERENCE TEST Are you willing to lose 1/3 of your income for a chance of doubling your income? No Yes Are you willing to lose 1/5 of your income for a chance of doubling your income? Are you willing to lose 1/2 of your income for a chance of doubling your income? No Yes No Yes Least Risk Tolerant Somewhat Risk Tolerant More Risk Tolerant Most Risk Tolerant like the example shown in Figure A1, rely on skippattern responses.24 When enough items are asked and responses from the answered items analyzed, estimates of constant relative risk aversion (the inverse of risk tolerance) can be derived. Constant relative risk aversion can then be used to estimate an investor’s utility function in the context of portfolio selection along the efficient frontier. In the risk-profiling methodology presented in this report, however, a revealed preference score is not intended to be used in isolation. Instead, scores from a revealed preference test should, as Alessandro Bucciol and Marina Stuefer note, be used in the risk-profiling process as a proxy for financial risk tolerance or as an “indicator of self-assessed risk attitude” (p. 23).25 Before selecting a revealed preference measure, asking the test developer about the tool’s validity and reliability is important, as is keeping in mind that given the way questions are presented in most revealed preference tests, a reliability estimate using a traditional estimate, such as Cronbach’s alpha, may not be available. Instead, a test developer should provide a reliability estimate based on test-retest data (i.e., an illustration of test scores by the same person over time). Conclusion To review, the first step when selecting a risktolerance measure involves conducting a validity review. Essentially, this means determining whether the questions included in a questionnaire or test, and the resulting output, “look” and “feel” right. This is not always a statistical test but sometimes an assessment based on professional judgment. Once one or more potential questionnaires have been identified for potential use in the risk-profiling process, the following checklist can be used to refine the risktolerance questionnaire decision choice.26 Checklist for Evaluating RiskTolerance Measurement Tools • • • The questionnaire developer’s website or marketing material documents questionnaire validity. The questionnaire developer’s website or marketing material documents questionnaire reliability via test-retest scores or Cronbach’s alpha (a ³ 0.70). The questionnaire includes a variety of questions and scenarios (minimum of seven questions) The questions in Figure A1 are from Robert B. Barsky, F. Thomas Juster, Miles S. Kimball, and Matthew D. Shapiro, “Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study,” Quarterly Journal of Economics 112 (May 1997): 537–579. 25 Alessandro Bucciol and Marina Stuefer, “Measuring Household Financial Risk,” Journal of Wealth Management 15, no. 3 (Winter 2012): 20–29. 26 Adapted from Michael Joseph Roszkowski, Geoff Davey, and John E. Grable, “Insights from Psychology and Psychometrics on Measuring Risk Tolerance,” Journal of Financial Planning 18, no. 4 (April 2005): 66–77. 24 CFA Institute | 17 Investment Risk Profiling • • • that relate to the type of product or service being offered (e.g., investing, savings choices, business ownership). The individual questions are free of biased language. Questionnaire scores have been correlated (with a statistical correlation coefficient) to other measures of financial risk taking (e.g., participation in the stock market, portfolio holdings). The scoring methodology and question weighting are clearly stated and free of objective factors (e.g., time horizon, age, liquidity, risk capacity). These factors should be measured independently within the broader risk profile, not “averaged” into a single score measure. Assuming a measurement tool exhibits elements of validity and reliability, the decision to use a risktolerance questionnaire or revealed preference test should be driven by ease of use, the quality of documentation provided by the tool’s vendor, and ongoing documentation of validity and reliability. The final risk-tolerance score—derived from either a questionnaire or a revealed preference test—can then be incorporated into the risk-profiling process as described in this report. APPENDIX B Regulatory Background and Risk-Profiling Requirements Regulators and boards of professional practice in all major developed markets require advisory firms and financial advisors to assess and evaluate an investor’s risk profile (or more precisely, the elements of an IRP).27 Consider the FINRA customer due diligence requirements as prescribed in the United States. Customer due diligence rules require financial advisors to take steps to understand the nature and purpose of a customer relationship. FINRA rules further state that a firm or financial advisor must28 have a reasonable basis to believe that a transaction or investment strategy involving securities that are or have been recommended to an investor are suitable. . . . [A] reasonable basis underlying suitability is due diligence to assess an investor’s investment profile, which can be comprised of a risk-tolerance assessment, an investor’s age, other investments, financial needs, tax status, investment objectives, experience, time horizon, liquidity need, and other factors. The Investment Industry Regulatory Organization of Canada has a similar rule whereby a financial advisor must be able to demonstrate that an investor’s willingness and ability to take risks have been measured and evaluated before an investment recommendation is developed.29 In the European Union, Article 25 of the Markets in Financial Instruments Directive II states, When providing investment advice or portfolio management the investment firm shall obtain the necessary information regarding the investor’s knowledge and experience in the investment field relevant to the specific type of product, that person’s financial situation including his ability to bear losses, and his investment objectives including his risk tolerance. In the United States, the Certified Financial Planner Board of Standards, Inc., as an element of its Code of Ethics and Standards of Conduct, also mandates the measurement of risk-profiling factors for those who hold the CFP® certification:30 A CFP® professional must act with the care, skill, prudence, and diligence that a prudent professional would exercise in light of the Client’s goals, risk tolerance, objectives, and financial and personal circumstances. (p. 3) Similarly, the Association of International Certified Public Accountants mandates that those who hold the Personal Financial Specialist (PFS) designation, as part of the Certified Public Accountant/PFS Body See FINRA’s Customer Due Diligence Requirements for Financial Institutions (CDD Rule) and FINRA Rule 3310 (Anti-Money Laundering Compliance Program). 28 Based on FINRA rules, investor financial risk profiles may consist of individualized risk scoring that allows an investor to be categorized into an appropriate investment classification. 29 See Shawn Brayman, Michael Finke, Ellen Bessner, John Grable, Paul Griffin, and Rebecca Clement, Current Practices for Risk Profiling in Canada and Review of Global Best Practices (Toronto: Investor Advisory Panel of the Ontario Securities Commission, 2015). http://www.osc.gov.on.ca/documents/en/Investors/iap_20151112_risk-profiling-report.pdf. 30 Certified Financial Planner Board of Standards, Inc., Code of Ethics and Standards of Conduct (Washington, DC: Certified Financial Planner Board of Standards, 2018). https://www.cfp.net/docs/default-source/for-cfp-pros---professional-standards-enforcement/ CFP-Board-Code-and-Standards. 27 18 | CFA Institute Investment Risk Profiling of Knowledge, assess elements of an investor’s risk profile,31 reviewing client investment preferences and risk tolerance to help them develop appropriate investment strategies. (p. 8) Globally, CFA Institute, in its Standards of Practice Handbook (11th edition), directs the following:32 When Members and Candidates are in an advisory relationship with a client, they must . . . make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly. (p. 9) Given the way existing rules have been written, nearly all “risk-profiling” tools in the marketplace can be used to meet regulatory customer due diligence requirements.33 In addition, nearly all existing tools provide a basis for investor–advisor risk–return discussions. Financial advisors who are merely looking for a regulatory compliance tool therefore have access to multiple alternatives. Additional assessment is required for those who wish to use the risk-profiling process described in this report. APPENDIX C Risk-Profiling Terminology Consequence of Goal Failure: The subjective acceptability of failing to accomplish a financial goal. Can be used as a scale whereby a high magnitude of unacceptability of failing to accomplish an investor’s goals would require higher relative weighting of the investor’s risk-need factor and vice versa. Financial Knowledge: An investor’s financial literacy concerning investing and risk–return dynamics. Higher knowledge is generally associated with higher willingness to take investment risk. Goal Time Horizon: Length of time, generally stated in years, between the present moment and the target goal achievement date. Generally related to age but not interchangeable. Investing Experience: Related to financial knowledge but can be gained only by “living through” various economic cycles—in particular, severe economic downturns. Contrary to knowledge, experience can be associated with high or low willingness to take financial risk, given that an investor’s past experiences naturally influence his perception of the riskiness of a possible future investment. Investment Risk Profile (IRP): The combination of factors about an investor that are expected to affect the level of portfolio risk that would be appropriate for a financial advisor to recommend. Generally, an IRP will include all the factors listed in this appendix, along with any other unique circumstances, tax/legal considerations, biases, or personality traits. Market Risk Environment: The market interest rate, inflation, and return expectations that exist at the time of assessment. Need for Liquidity: An objective need or desire to hold cash for ongoing current or future expected distribution needs. High need for liquidity is often related to a short time horizon. Risk Capacity: Otherwise known as an investor’s ability to sustain portfolio volatility without material effect on the investor’s standard of living or capability to meet stated goals. High risk capacity is often related to the existence of an emergency fund, current outside and/ or employment income, access to credit, insurance coverage, etc. Risk Composure: An individual’s past penchant for behaving in a consistent manner. An example assessment would be to enquire how an individual responded to the global financial crisis of 2008–2009: Did she or he sell, hold, or buy more? Risk Need: The magnitude of risk necessary to achieve a financial goal, based on predetermined levels of expected return. The related required RoR determination, calculated from present/future value models, can be adjusted and reevaluated via manipulation of the input factors (present value, future value, number of payments, interest rate, payment). Association of International Certified Professional Accountants, PFS Credential Handbook: A Guide to the AICPA Personal Financial Specialist Credential (Durham, NC: Association of International Certified Professional Accountants, 2019). https://www.aicpa.org/content/dam/aicpa/ membership/join/downloadabledocuments/pfs-credential-handbook.pdf. 32 CFA Institute, Standards of Practice Handbook, 2014, 11th ed. (Charlottesville, VA: CFA Institute, 2014). https://www.cfainstitute.org/-/media/ documents/code/code-ethics-standards/standards-practice-handbook-11th-ed-eff-July-2014-corr-sept-2014.ashx. 33 Regulators have not historically prescribed validity, reliability, design, or interpretation guidelines related to risk-profiling tools, making nearly all risk-tolerance and risk-profiling assessment tools compliant with regulations. 31 CFA Institute | 19 Investment Risk Profiling Risk Perception: An individual’s cognitive assessment of the riskiness of a given situation, regardless of the objective truth. Perception can be heavily influenced by the media and an individual’s social environment, as well as a lack of thorough understanding of financial concepts. Risk Preference: An individual’s general feeling or partiality toward one or more options over another/ others. Preference is a rank order of preferred choices. Although investors are assumed to be risk averse, some may have a greater preference for “return maximization” over “risk reduction.” Risk Tolerance: The maximum level of uncertainty an individual is willing to tolerate in exchange for incremental units of return. This term is often used interchangeably in everyday nomenclature to mean “risk profile” or “risk attitude”; however, in practice, risk tolerance is an individual’s willingness to implement a risky strategy after all other factors have been considered. APPENDIX D In the context of this report, a risk profile is the combination of an investor’s risk need, risk-taking ability, and behavioral loss tolerance. Given that each factor may be characterized with three levels of intensity, 27 IRP combinations are possible.34 For example, an investor with a very high IRP can be described as high need (HN), high ability (HA), and high tolerance (HT). An investor with a very low IRP can be described as low need (LN), low ability (LA), and low tolerance (LT). However, rarely do all three factors align perfectly. Essentially, each IRP can be thought of as representing a different “risk personality.” An investor’s unique combination of IRP factors, as shown in Table D1, can be used by an investor, financial advisor, educator, or regulator when calibrating an investor’s IRP into a portfolio asset allocation recommendation. This calibration process is analogous to a traffic light that instructs drivers to proceed on green, use caution on yellow, and stop on red. The following risk-profiling rules apply when using the IRP technique outlined in this report: • An investor’s risk need cannot be higher than the investor’s risk-taking ability associated with the goal. • • • • • • Doing so will trigger an automatic red light, indicating that the investor’s goal must be reevaluated to realign with her risktaking ability. A lower risk need is ignored when both risk-taking ability and behavioral loss tolerance are higher. Higher risk-taking ability is ignored when both the risk need and behavioral loss tolerance are lower. Higher behavioral loss tolerance is ignored when both the risk need and risk-taking ability are lower. Low behavioral loss tolerance can never be ignored; however, behavioral loss tolerance can be used to “nudge” an investor into a higher-risk portfolio when the risk need and risk-taking ability are higher. A financial advisor should not recommend a portfolio allocation that exceeds an investor’s risktaking ability. • Risk-taking ability sets an upper volatility bound to a portfolio recommendation. Green Light Profiles Some IRP combinations represent “green light” profiles, meaning that no further calibration or data are necessary to make an appropriate portfolio allocation recommendation. For example, if an investor’s IRP is HN, HA, and HT, a financial advisor can reasonably recommend a “high volatility portfolio,” which for risk-profiling purposes is defined as a portfolio with at least 70% exposure to growth assets (equities and alternatives). In the same way, a “moderate volatility portfolio” is one with 30% to 70% exposure to growth assets, and a “low volatility portfolio” is one with less than 30% exposure to growth assets. Yellow Light Profiles “Yellow light” IRPs signal that an investor’s behavioral loss tolerance is lower than either his risk need or risktaking ability. This means the investor may need some additional behavioral interventions before investing in a portfolio more consistent with his risk need and risk-taking ability. Although 27 IRP combinations ultimately exist, only “green light” and “yellow light” IRP combinations, 18 in total, are acceptable when making portfolio allocation recommendations. 34 20 | CFA Institute Investment Risk Profiling It may be appropriate for a financial advisor to “nudge” an investor into a higher volatility portfolio in yellow light cases. This behavioral “nudge,” or soft paternalism,35 may be necessary to promote what is objectively in the best long-term interest of the investor; however, this should not be automatically assumed. In practice, 55% of investors understand that they need to take investment risk to achieve their goals; however, 52% of investors prefer to miss goal achievement rather than take additional investment risk.36 Red Light Profiles With this in mind, referencing the consequence of failing to meet a stated goal is appropriate. If the consequence is high, financial advisors should recommend a portfolio consistent with the investor’s risk need and risk-taking ability. However, if the consequences of failure are low, financial advisors should initially recommend a portfolio consistent with the investor’s behavioral loss tolerance and attempt to improve the investor’s financial knowledge and investing experience over time. When the risk need exceeds risk-taking ability, an investor and her financial advisor must reevaluate the investor’s goals and expectations to bring them in line with the investor’s risk-taking ability, regardless of the investor’s level of behavioral loss tolerance. A red-light situation means that making a portfolio allocation recommendation will be possible only when the investor’s risk need and corresponding required RoR need are adjusted downward. For example, a financial advisor could recommend that an investor work longer, When the required RoR (i.e., risk need) and corresponding portfolio volatility needed to accomplish an investor’s stated goal exceed an investor’s risktaking ability—whether this is because of a short time horizon, liquidity constraints, or a lack of risk capacity— an automatic “red light” is triggered. TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING Risk Need RiskTaking Ability Behavioral Loss Tolerance Green/ Yellow/ Red Light High High High Mod High Low Recommendation Strategy Green Light Proceed: Allocate to High Volatility Portfolio All factors align; move forward with portfolio implementation. High Green Light Proceed: Allocate to High Volatility Portfolio Moderate need can be safely ignored; move forward with portfolio implementation. High High Green Light Proceed: Allocate to High Volatility Portfolio Low need can be safely ignored; move forward with portfolio implementation. Mod Mod Mod Green Light Proceed: Allocate to Moderate Volatility Portfolio All factors align; move forward with portfolio implementation. Mod High Mod Green Light Proceed: Allocate to Moderate Volatility Portfolio High ability can be safely ignored; move forward with portfolio implementation. Low Mod Mod Green Light Proceed: Allocate to Moderate Volatility Portfolio Low need can be safely ignored; move forward with portfolio implementation. (Continued) See Richard H. Thaler and Cass R. Sunstein, “Libertarian Paternalism,” American Economic Review 93, no. 3 (May 2003): 175–179. See David Blake and Alistair Haig, How Do Savers Think About and Respond To Risk? Evidence from a Population Survey and Lessons for the Investment Industry (London: The Pensions Institute, 2014). 35 36 CFA Institute | 21 Investment Risk Profiling TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING (CONTINUED) Risk Need RiskTaking Ability Behavioral Loss Tolerance Green/ Yellow/ Red Light Low High Mod Low Low Low Recommendation Strategy Green Light Proceed: Allocate to Moderate Volatility Portfolio Both low need and high ability can be safely ignored in favor of moderate tolerance; move forward with portfolio implementation. Low Green Light Proceed: Allocate to Low Volatility Portfolio All factors align; move forward with portfolio implementation. High Low Green Light Proceed: Allocate to Low Volatility Portfolio High ability can be safely ignored; move forward with portfolio implementation. Low Mod Low Green Light Proceed: Allocate to Low Volatility Portfolio Moderate ability can be safely ignored; move forward with portfolio implementation. Mod Mod High Yellow Light Caution: Allocate to Moderate Volatility Portfolio after Discussion with Investor Investor’s loss tolerance exceeds investor’s risk-taking ability; investor may expect or have a desire to take on more volatility than is prudent; some education may be required. Low Mod High Yellow Light Caution: Allocate to Moderate Volatility Portfolio after Discussion with Investor Investor’s loss tolerance exceeds investor’s risk-taking ability; investor may expect or have a desire to take on more volatility than is prudent; some education may be required. Low need can be safely ignored. Low Low High Yellow Light Caution: Allocate to Low Volatility Portfolio after Discussion with Investor Investor’s loss tolerance exceeds investor’s risk-taking ability; investor may expect or have a desire to take on more volatility than is prudent; some education may be required. Low Low Mod Yellow Light Caution: Allocate to Low Volatility Portfolio after Discussion with Investor Investor’s loss tolerance exceeds investor’s risk-taking ability; investor may expect or have a desire to take on more volatility than is prudent; some education may be required. High High Mod Yellow Light Caution: Allocate Only after Discussion with Investor Investor’s loss tolerance is lower than investor’s risk need and risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goals; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary. (Continued) 22 | CFA Institute Investment Risk Profiling TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING (CONTINUED) Risk Need RiskTaking Ability Behavioral Loss Tolerance Green/ Yellow/ Red Light High High Low Mod High Mod Recommendation Strategy Yellow Light Caution: Allocate Only after Discussion with Investor Investor’s loss tolerance is lower than investor’s risk need and risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goals; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary. Low Yellow Light Caution: Allocate Only after Discussion with Investor Investor’s loss tolerance is lower than investor’s risk need and risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goals; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary. Mod Low Yellow Light Caution: Allocate Only after Discussion with Investor Investor’s loss tolerance is lower than investor’s risk need and risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goals; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary. High Mod High Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability. Even though investor’s need and tolerance allow for a high volatility portfolio, investor has only a moderate ability and can withstand only a moderate volatility strategy. High Mod Mod Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability. Investor has only a moderate ability and can withstand only a moderate volatility strategy. High Mod Low Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goal; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary instead. Investor has only a moderate ability and can withstand only a moderate volatility strategy. (Continued) CFA Institute | 23 Investment Risk Profiling TABLE D1.  HUBBLE–GRABLE THREE-FACTOR MODEL OF INVESTOR RISK PROFILING (CONTINUED) Risk Need RiskTaking Ability Behavioral Loss Tolerance Green/ Yellow/ Red Light High Low High High Low High Recommendation Strategy Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goal; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary instead. Investor has a low ability and can withstand only a low volatility strategy. Mod Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability; some education may be needed to encourage investor to increase volatility to meet goal; do not assume investor is willing to increase volatility exposure; reevaluating investor’s goal to align with the behavioral loss tolerance score may be necessary instead. Investor has a low ability and can withstand only a low volatility strategy. Low Low Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability. Investor has a low ability and can withstand only a low volatility strategy. Mod Low High Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability, and investor’s loss tolerance exceeds investor’s risk-taking ability; investor may expect or have a desire to take on more volatility than is prudent; additional education is warranted. Investor has a low ability and can withstand only a low volatility strategy. Mod Low Mod Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability, and investor’s loss tolerance exceeds investor’s risk-taking ability; investor may expect or have a desire to take on more volatility than is prudent; additional education is warranted. Investor has a low ability and can withstand only a low volatility strategy. Mod Low Low Red Light Stop: Goal Achievement Problematic; Reevaluate Goals Reestablish investor expectations; investor’s risk need exceeds investor’s risk-taking ability. Investor has a low ability and can withstand only a low volatility strategy. 24 | CFA Institute