Investment Risk Profiling: A Guide for Financial Advisors PDF

INVESTMENT RISK PROFILING A GUIDE FOR FINANCIAL ADVISORS © 2020 CFA Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, w...

INVESTMENT RISK PROFILING A GUIDE FOR FINANCIAL ADVISORS © 2020 CFA Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission of the copyright holder. Requests for permission to make copies of any part of the work should be mailed to: Copyright Permissions, CFA Institute, 915 East High Street, Charlottesville, Virginia 22902. CFA®, Chartered Financial Analyst®, CIPM®, Investment Foundations™, and GIPS® are just a few of the trademarks owned by CFA Institute. DISCLAIMER This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. Furthermore, the publisher is not providing investment advice or endorsing any methodology. The cases included in the report are not an endorsement of the people, products, or firms mentioned in the cases; investment product returns are unpredictable. If expert assistance is required, the services of a competent professional should be sought. Photo credit: Maskot / Maskot / Getty Images ISBN: 978-1-942713-92-0 INVESTMENT RISK PROFILING A GUIDE FOR FINANCIAL ADVISORS CONTENTS Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The Investment Risk Profile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 A Framework for the Construction of an Investment Risk Profile . . . . . . . . . . . . . . . . . . . . . . . . 4 Factor 1 of 3: Establishing an Investor’s Risk Need . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Factor 2 of 3: Establishing an Investor’s Risk-Taking Ability . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Factor 3 of 3: Establishing an Investor’s Behavioral Loss Tolerance . . . . . . . . . . . . . . . . . . . . . . 8 Reconciling and Relating the IRP to a Portfolio Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Assessing and Choosing a Risk-Tolerance Measure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Checklist for Evaluating Risk-Tolerance Measurement Tools . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Appendix B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Regulatory Background and Risk-Profiling Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Appendix C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Risk-Profiling Terminology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Appendix D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Green Light Profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Yellow Light Profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Red Light Profiles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Case Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Case One . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Case Two . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 CE Qualified Activity This publication qualifies for 1 CE credit under the guidelines of the CFA Institute Continuing Education Program. EXECUTIVE SUMMARY Establishing an investment risk profile (IRP) is an essential part of structuring an investor’s investment portfolio, and the IRP is an integral element of an investor’s investment policy statement. Financial advisors must use their best professional judgment to determine how investors can achieve financial goals through appropriate portfolio security selection. However, doing so requires balancing return objectives with the risk of variation in returns—in particular, the risk of negative returns. Current financial advisor practices vary significantly and, with the advent of new digital tools, often revolve around a single characterization of an investor’s “risk tolerance” and/or a similar summary characterization of an investor’s appetite for portfolio risk. In addition, although current regulatory guidelines require a consistent process for compliance, prescriptive standards for how and in what manner IRP data should be measured or applied are lacking. An important financial advisory skill is the ability to develop a comprehensive representation of an investor’s IRP. A robust IRP measure provides a pathway to ensure that any proposed portfolio strategy is fit for the purpose with respect to achieving an investor’s goals. This requires careful analysis and synthesis of three dimensions of an IRP: • An investor’s need for risk should be assessed by considering the required rate of return (RoR) on the investment portfolio to fulfill the investor’s future lifestyle, charitable, and dynastic goals. In concert with capital markets expectations, • • a calculated required portfolio RoR will suggest potential asset allocation strategies that align with market risks. An investor’s ability to take risk includes the investor’s time horizon, potential need for liquidity, and risk capacity. These factors will determine the investor’s financial ability to withstand declines in portfolio values. The ability to take risk can often be a limiting factor when considering an investor’s need for risk to meet corresponding goals. An investor’s behavioral loss tolerance can upset the most carefully devised quantitative portfolio strategy. Best practice is to use psychometric tools (often questionnaires) that have demonstrated reliability and validity in predicting an investor’s emotional and behavioral tendencies around loss of portfolio value and investing discipline. Having independently analyzed the three dimensions that comprise an IRP—risk need, risk-taking ability, and behavioral loss tolerance—the financial advisor must then reconcile these dimensions into a portfolio consistent with the investor’s IRP. This report proposes best practices with regard to investment risk profiling: Financial advisors should strive to combine straightforward calculations of risk need, careful assessment of risk-taking ability, and a robust examination of investor behaviors and attitudes to create the foundation for portfolio strategies and accompanying investment and financial planning decisions. CFA Institute | 1 INTRODUCTION At the heart of the relationship between financial advisors and their clients is the process by which a client’s current financial state is related to the client’s investment aspirations for the future. The value of current assets, future savings and spending, and risks undertaken to achieve desired investment returns work together to shape the success or failure of goal achievement. When working with investors, financial advisors face the following complex dilemma: Given that reward is not possible without risk, just how much risk is appropriate? and law (Appendix B provides additional details about the regulatory environment). Under common law standards, financial advisors are expected to ensure that investors are aware of the potential risks associated with available options. Less well prescribed, however, are how investor information is obtained and how that information is presented to investors. This has created an environment in which the use of risk-profiling tools varies dramatically from one advisor and firm to another, as do the subsequent portfolio recommendations. Because of repeated episodes of misconduct, regulators globally have been taking steps to require firms and financial advisors to somehow assess the risk-related attributes or “profile” of a prospective or current client when developing and justifying investment recommendations. Currently, the assumption is that as long as firms and financial advisors can readily document a consistent evaluation process, regulatory requirements will be met. However, uncertainty surrounds this assumption because few standards or restrictions with respect to “how” to make a risk-profile assessment have been prescribed or enforced. For this reason, financial advisors have typically viewed the risk-profiling process primarily as a regulatory hurdle. When conceptualized as a threshold measure, rather than a tool to guide the development of a portfolio strategy and financial recommendations, the risk-profiling documentation requirement has been met using short risk-tolerance questionnaires and assessment tests along with, at a minimum, an acknowledgment of an investor’s age and financial circumstances. Given the gap in practice standards, numerous commercial firms have entered the risk-tolerance and risk-profiling assessment marketplace.1 Some of these firms provide products that are intended to meet minimum regulatory compliance requirements (i.e., the investor risk profile provides a starting point in investor discussions). Scores are generally presented on a numerical scale from very low to very high, but rarely are these scores defined in terms of an investment recommendation. Other firms provide more robust measures related to an investor’s IRP (investment risk profile). What makes matters even more confusing for the typical financial advisor is that no recognized regulatory body imposes specific guidelines regarding how the results of a risk profile should be directly applied to portfolio recommendations. In most jurisdictions, common law gives broad discretion to financial advisors using their professional judgment, which is a similar standard applied in other professional activities, such as medicine, accounting, Essentially, all “risk-profiling” tools in the marketplace can be used to meet regulatory customer due diligence requirements.2 In addition, nearly all existing tools provide a basis for investor–advisor risk–return discussions. As a result, financial advisors who are merely looking for a regulatory compliance tool have access to multiple alternatives. The purpose of this report is to present a framework of best practices that financial advisors, educators, and regulators can use to specify, measure, and evaluate objective and behavioral factors unique to an investor, which can then be assessed and combined into an IRP. This report provides a methodology that financial advisors can follow to guide the development of investment portfolio strategies that reconcile an investor’s goals, assets, savings, and willingness to assume risk, affirming the intent of regulatory requirements and improving investor outcomes relative to each investor’s investment goals. Nearly all broker/dealers and custodians require advisor staff to use in-house–developed risk-profiling tools. 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, by default, compliant with regulations. 1 2 2 | CFA Institute Investment Risk Profiling THE INVESTMENT RISK PROFILE The primary purpose of the risk-profiling process is to ensure that investment and financial recommendations match an investor’s financial and emotional aptitude to engage in financial transactions, at the household level, that entail financial/investment risk. We begin by presuming that a financial advisor collects necessary objective and behavioral information from and about an investor with the intention of making investment recommendations that are always in the investor’s best interests and that align with the investor’s IRP. When viewed from this perspective, the use of an IRP is analogous to deciding how fast to drive a car: • • • • Before embarking, a driver makes a mathematical estimate of how long the journey will take, and thus how fast she or he needs to drive to arrive at the appointed time. At the same time, the driver applies subjective probabilities to assess the severity and consequences of arriving late. Along the way, the driver faces limitations with respect to how fast her car can actually go; this ability factor is equivalent to a regulatory speed limit, the amount of fuel the car has, and the traffic conditions the driver encounters. Finally, the driver’s behavioral preferences come into play; some drivers, for instance, get a thrill out of driving aggressively, regardless of the possible consequences of being pulled over by law enforcement or getting in an accident, whereas others prefer a more cautious journey. Each of these elements—need, ability, and behavioral loss tolerance—plays a distinct role in shaping how fast someone drives. One factor alone is insufficient to predict a trip’s characteristics. The combination of driver, car, and environmental characteristics is what shapes the driving profile of each trip. Similarly, multiple factors must be combined in the development of an IRP. Financial advisors use an analytical process to evaluate what level of portfolio risk (e.g., often simply volatility as measured by standard deviation or its derivative, with more sophisticated downside measures and/or value at risk calculations increasingly common) is appropriate for a particular investor. Conventional wisdom and practice standards, based on heuristic models, often lead financial advisors to base investment and portfolio recommendations primarily on an investor’s age, so a younger investor is generally encouraged to take more risk, whereas an older investor, all else being equal, is positioned to take less risk. However, the use of just one investor characteristic, such as age, can lead to improper alignment of an investor’s need, ability, and behavioral loss tolerance associated with taking investment risk. Risk need, the ability to take risk, and the behavioral tolerance to engage in risk-taking activities often exist contradictorily within a single investor. An investor’s risk need, ability to take risk, and behavioral loss tolerance are also subject to change based on investor and environmental circumstances. Conceptually, the elements comprising an IRP can be grouped according to three factors. As shown in Figure 1, these factors are (1) risk need, (2) risk-taking ability, and (3) behavioral loss tolerance. FIGURE 1.  IRP FACTORS AND RELATED ELEMENTS Risk Need Risk-Taking Ability Behavioral Loss Tolerance • Required Rate of Return (%) • Market Risk Environment • Consequence of Failure • Time Horizon • Need for Liquidity • Risk Capacity • Risk Tolerance • Risk Preference • Financial Knowledge • Investing Experience • Risk Perception • Risk Composure CFA Institute | 3 Investment Risk Profiling A FRAMEWORK FOR THE CONSTRUCTION OF AN INVESTMENT RISK PROFILE What follows is a description of each factor in the riskprofiling process (as illustrated in Figure 1), a review of the elements comprising each factor, and an example of how a financial advisor can measure/evaluate each element. This is followed by an explanation of how the factors can be combined into a comprehensive IRP for use in making portfolio allocation recommendations. Two points are worth noting: • • In the context of this report, risk refers to the degree of potential financial loss inherent in an investment decision, generally measured by downside portfolio standard deviation or a derivative of standard deviation (i.e., volatility). Uncertainty refers to a situation in which a decision maker lacks information about known probabilities before making a decision. For example, investment decisions are uncertain, whereas gambling decisions involve risk. Investors tend to be more averse to uncertainty than to risk. As a result, investors are apt to act based on perceptions of risk rather than on actual risk.3 Although researchers, risk-profiling firms, and regulators have taken steps to standardize riskprofiling terms and definitional guidelines, to date, reaching a general consensus about risk-profiling terminology has been challenging. The definitions used in this report (see Appendix C) are based on the work of researchers across the finance, financial planning, psychology, and business management fields.4 Factor 1 of 3: Establishing an Investor’s Risk Need • Required Rate of Return (%) • Market Risk Environment • Consequence of Failure Risk Need The first factor comprising an IRP is related to establishing investor goals and the required return needed to grow or preserve current assets to fund future goals. Essentially, this step in the IRP development process is equivalent to relating a required rate of return (RoR) to capital markets expectations and thus potential portfolio risk. Often, an investor may need assistance from a financial advisor to develop required returns and associated risk needs, which can include jointly developed assumptions regarding how long the investor will work, how much the investor will save or spend yearly, and whether the investor has a desire to leave a bequest for his family or a charity. The required RoR estimate can be objectively measured using one or more present/future value calculations. Alternatively, some financial advisors may choose to take a balance sheet approach and characterize the present value of assets (including discounted future cash flows) and the present value of liabilities (investor goals). In the context of an IRP, one should note that for an investor to express more than one financial goal is not unusual. Rather than aggregating investor goals, the framework presented in this report treats each goal separately, which implies that a financial advisor Michael Joseph Roszkowski and Geoff Davey, “Risk Perception and Risk Tolerance Changes Attributable to the 2008 Economic Crisis: A Subtle but Critical Difference,” Journal of Financial Services Professionals 64, no. 4 (July 2010): 42–53. 4 See the following sources: 3 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. Nicholas Carr, “Reassessing the Assessment: Exploring the Factors That Contribute to Comprehensive Financial Risk Evaluation” (PhD diss., Kansas State University, 2014). A. Hubble, “The Amalgamation of Professional Judgement: A Mean–Variant Approach from an International Survey of Financial Advisers” (PhD diss., University of Georgia, 2018). Liana Holanda Nepomuceno Nobre, and John E. Grable, “The Role of Risk Profiles and Risk Tolerance in Shaping Investor Decisions,” Journal of Financial Service Professionals 69, no. 3 (May 2015): 18–21. Liana Holanda, N. Nobre, John E. Grable, Wesley Vieira da Silva, and Fabio Chaves Nobre, “Managerial Risk Taking: A Conceptual Model for Business Use,” Management Decision 56, no. 11 (2018): 2487–2501. https://www.emeraldinsight.com/doi/pdfplus/10.1108/ MD-09-2017-0892. 4 | CFA Institute Investment Risk Profiling should estimate a unique IRP for each goal. This riskprofiling approach is based on the mental accounting observations of Richard H. Thaler5 and others,6 which suggest that investors will have a distinct risk profile based on a specific goal. The goal should be stated specifically and in measurable terms as a pathway to estimating an RoR or internal rate of return necessary to accomplish each account/goal. The goal at this stage of the risk-profiling process is to assess the risk an investor needs to take (or the volatility an investor must be willing to endure) to achieve the goal.7 The risk-need factor comprises three elements: (1) required RoR (%), (2) market risk environment, and (3) consequence of failure. Each element is described as follows: Required RoR As conceptualized in this report, the required RoR is synonymous with risk need, which refers to the amount of portfolio risk an investor must accept to meet a specific financial goal. Typically, risk need is expressed in terms of a real net (after inflation and fees) RoR or internal RoR figure. For example, assume an investor has a goal of accumulating $3.5 million at the end of 20 years. If the investor can save $75,000 annually, the investor needs to earn approximately 8.18% on an annualized basis to reach her goal. In this example, the investor’s risk need corresponds to a portfolio with an expected annual return of 8.18% and expected volatility derived from capital markets expectations, including volatility and correlation of returns among asset classes. In nearly all cases, the estimation of a risk need is a quantifiable step in the risk-profiling process that is well within the capability of most financial advisors using modern financial planning software and/or a spreadsheet analysis. In some situations, however, an RoR estimate may not be an appropriate measure of risk need. Consider, for example, an investor with a net worth of $35 million whose primary goal is capital preservation in relation to a later-life charitable bequest. This investor’s risk need may be low in relation to cash flow needs, primarily because the investor has the risk capacity to deal with portfolio losses. Nonetheless, estimating the investor’s risk profile is helpful in ensuring that an appropriate match is made between portfolio recommendations and the investor’s goal(s). Market Risk Environment The current market interest rate and inflation environment must also be evaluated when finalizing an investor’s risk need. A financial advisor’s assessment of the current and future market environment can play an important role in shaping portfolio development and allocation decisions. Factors that contribute to an assessment of the market environment include current equity, fixed income, and cash/cash equivalent returns compared with historical averages, current and projected inflation, and other factors that shape the risk premium an investor faces. Although these and other components can be quantified, financial advisors commonly apply professional judgment and models when evaluating the market environment. As part of the risk-profiling framework presented in this report, an advisor should assess whether the investor’s required RoR is realistic, given capital markets expectations, and when appropriate adjust the goal(s) and/or revisit assumed savings rates. Consequence of Failure The third element when assessing a goal is consequence of failure. Risk consequence refers to the financial and emotional threats an investor faces if a goal is not achieved. For example, some investors may consider that ensuring sufficient capital is available to pay for a grandchild’s college education is a goal with an acceptable consequence of failure, whereas others might consider that not achieving this goal is unacceptable. Goal consequence, therefore, is a key element in determining how much portfolio risk is appropriate to recommend. The consequence of failing to meet an investor’s goal is not specifically quantified within the risk-need factor. However, when combined with an investor’s ability to take risk and her behavioral loss tolerance (defined in detail later in this report), the severity of failing to meet a goal should be accounted for using the financial advisor’s judgment as to whether the advisor should “nudge” an investor toward a higher volatility Richard H. Thaler, “Mental Accounting and Consumer Choice,” Marketing Science 4, no. 3 (Summer 1985): 199–214. See Jean L. P. Brunel, “Revisiting the Asset Allocation Challenge through a Behavioral Finance Lens,” Journal of Wealth Management 6, no. 2 (January 2003): 10–20; Dan Nevins, “Goals-Based Investing: Integrating Traditional and Behavioral Finance,” Journal of Wealth Management 6, no. 4 (Spring 2004): 8–23; and Franklin J. Parker, “The Erosion of Portfolio Loss Tolerance over Time: Defining, Defending, and Discussing,” Journal of Wealth Management 19, no. 2 (July 2016): 23–31. 7 Categorizing the risk need as low, moderate, or high is used throughout this report to describe, in simple terms, how a risk profile can be developed for an investor. These categories can be expanded, depending on a financial advisor’s business model. 5 6 CFA Institute | 5 Investment Risk Profiling portfolio than what her behavioral loss tolerance would otherwise allow, assuming the investor has the financial ability to deal with the magnitude of potential losses associated with the risk need. For example, assume an investor’s RoR need is 8.18%, which in nearly all cases would be classified as a high risk need. If the consequence of failure is high, a financial advisor should present different scenarios and trade-offs associated with taking more portfolio risk and failing to meet the goal. Perhaps other solutions exist that will meet the investor’s needs, such as (1) saving more, (2) spending less, (3) working longer, or (4) reducing a bequest that could better align the investor’s risk need with his behavioral risk tolerance. Simplifying the Process Financial advisors may find that categorizing an investor’s goal as low, moderate, or high risk (as measured by exposure to volatility) is useful, once the required RoR has been estimated and the estimate has been confirmed through a market risk environment analysis. The following guidelines can be used to classify a risk need: Portfolio Composition of Growth Assets Necessary to Meet RoR (%) Risk-Need Categorization Less than 30% LOW Between 30% and 70% MODERATE Greater than 70% HIGH TABLE 1. FRAMEWORK FOR ESTABLISHING AN INVESTOR’S RISK NEED (CONTINUED) 4. What is the time horizon for accomplishing stated goal (years)? 5. What is the regular saving to (+)/spending from (–) the account? 6. What is the frequency of saving/spending (monthly/quarterly/yearly/occasionally)? 7. What is the estimated required RoR (%) to meet stated goal? 8. Given capital markets expectations and the current market risk environment, is this RoR realistic to obtain? 9. DECISION POINT: • Proceed or stop and revise goal and/or savings rate. 10. Financial consequence of failing to meet stated goal, if any: • Acceptable, unacceptable, unknown. Factor 2 of 3: Establishing an Investor’s Risk-Taking Ability • Time Horizon • Need for Liquidity • Risk Capacity Risk-Taking Ability Risk Need Summary The questions and tasks shown in Table 1 can be used to help guide the risk need estimation process for a given future goal. An investor’s risk-taking ability encompasses three elements: (1) goal time horizon, (2) need for liquidity, and (3) risk capacity (i.e., capacity to deal with a financial loss). Goal Time Horizon TABLE 1. FRAMEWORK FOR ESTABLISHING AN INVESTOR’S RISK NEED 1. What is the investor’s goal? 2. What is the future value need ($)? 3. What is the present value of investment account ($)? (Continued) 6 | CFA Institute Not only is an investor’s goal time horizon an input used to determine the risk need (i.e., the required RoR need), but it is also an important element describing risk-taking ability. Conceptually, the goal time horizon is the period between when a goal is established and the date of that goal’s achievement, which in some cases may exceed the investor’s remaining lifetime. All else being equal, investors with long goal time horizons have a greater capacity to withstand Investment Risk Profiling and recoup portfolio losses resulting from market volatility, compared with investors with shorter goal time horizons. Financial advisors should account for an investor’s goal time horizon when applying their professional judgment with respect to the investor’s ability to take risk. Simplifying the Process Financial advisors may find that classifying an investor’s goal time horizon as follows is useful in the risk-profiling process: • • • An investor is deemed to have a short goal time horizon if the time needed for goal achievement is five years or fewer. An investor is deemed to have a long goal time horizon if the time needed for goal achievement is 10 years or more. A goal time horizon that falls between these two points is defined as an intermediate time horizon. Need for Liquidity Need for liquidity is defined as an objective requirement or desire to hold cash for ongoing current or future expected distribution needs. During the capital accumulation phase of an investor’s lifespan, liquidity needs may be quite low—which would increase an investor’s ability to withstand market risk—whereas a liquidity need may be very high during the capital distribution phase of an investor’s lifespan—thus reducing the investor’s ability to incur investment risk. Financial advisors should account for the investor’s need for liquidity when applying their professional judgment with respect to the investor’s ability to take risk. Simplifying the Process Financial advisors may find that classifying the investor’s need for liquidity is useful in the riskprofiling process, doing so using the following guidelines: • • A net (after advisory fees) expected or ongoing annual distribution need of 5% or more of a portfolio’s value indicates a high liquidity need or a correspondingly low ability to take financial risk. An absence of expected distributions indicates a low liquidity need or a correspondingly high ability to take financial risk. Risk Capacity Risk capacity refers to an investor’s financial capability to withstand a financial loss without meaningfully compromising her desired standard of living. Risk capacity is often evaluated using objective investor characteristics. For example, risk capacity can be gauged by total investable assets relative to net worth and the amount of outside assets or income available to the investor to cover future or unexpected liabilities. If an investor has adequate cash savings, pension income, insurance, and/or access to credit to cover his standard-of-living needs should an unexpected loss occur as the result of an emergency or a market decline—without significantly relying on or affecting the value of portfolio assets dedicated to achieving investor goals—the investor would be considered to have a high risk capacity. If, however, a significant drop in portfolio value could compromise the investor’s standard of living, the financial advisor should consider the investor’s risk capacity low. Consider an investor with a long goal time horizon, low need for liquidity, and high degree of wealth or outside sources of income in relation to daily standard-of-living needs. This type of investor would generally be considered to have a high ability to take financial risk. All else being equal, recommending a portfolio that has a risk (volatility) need greater than the investor’s risk-taking ability allows would be considered imprudent regardless of the investor’s risk need or behavioral loss tolerance (described later in this report). Risk-Taking Ability Summary Although some subjectivity is involved, consideration of an investor’s goal time horizon, liquidity needs, and capacity to take risk all inform a financial advisor’s professional judgment about the investor’s risk-taking ability. Note that the ability elements, more than the other IRP elemental factors, will change, often significantly, throughout the goal timeline. These elements should be revisited whenever an investor’s situation (financial or otherwise) changes dramatically and as the goal moves closer to completion, primarily because an investor’s ability to take risk generally declines as the goal nears. Simplifying the Process Financial advisors may find that classifying an investor’s risk-taking ability as follows is useful in the risk-profiling process: CFA Institute | 7 Investment Risk Profiling If EITHER of the following situations is present, the investor’s ability to take risk is LOW: 9 Time horizon is less than or equal to five years. 9 The expected and/or ongoing annual liquidity need is greater than or equal to 5% of the portfolio value and no outside income or assets (e.g., employment income, access to credit, cash savings, insurance) are available to maintain standard of living in case of an emergency. If ALL of the following scenarios are present, the investor’s ability to take risk is HIGH: 9 Time horizon is greater than or equal to 10 years. 9 Investor has no expected and/or ongoing annual liquidity needs that are greater than 5% of the portfolio value. 9 Sufficient outside income or assets (e.g., current income, access to credit, cash savings, insurance) are available to maintain standard of living in case of an emergency. Otherwise, the investor’s ability is MODERATE. Factor 3 of 3: Establishing an Investor’s Behavioral Loss Tolerance • Risk Tolerance • Risk Preference • Financial Knowledge • Investing Experience • Risk Perception • Risk Composure Behavioral Loss Tolerance Although, in general, the first two IRP factors are easily measured with objective data points—that is, each element can be calculated using financial software, spreadsheet packages, or a financial calculator with time value of money capabilities—elements of behavioral loss tolerance tend to be subjective and unique to each investor. As such, an investor’s behavioral loss tolerance must usually be inferred from the administration of appropriately designed questionnaires, tests and scales, and conversations with the investor, as well as/or by examining the investor’s past behavior with regard to asset allocation decisions. Relying on just one of these inputs can result in a skewed assessment of an investor’s emotional wherewithal to engage in risky financial behaviors. In the context of the risk-profiling process described in this report, an investor’s behavioral loss tolerance can be described by six elements: (1) (2) (3) (4) (5) (6) risk tolerance risk preference financial knowledge investing experience risk perception risk composure Unless a financial advisor is using a fit-for-purpose behavioral loss tolerance questionnaire, each of these elements must be assessed independently.8 The six elements comprising this factor are described in greater detail in the following sections. Risk Tolerance Risk tolerance (i.e., willingness to take risk) represents the maximum amount of uncertainty an investor is willing to accept when making a financial decision.9 Risk tolerance can also be conceptualized as an investor’s inclination to engage in financial behavior whose outcome is unknown and potentially negative.10 Risk aversion is the inverse of risk tolerance. In general, one can reasonably assume that an investor’s financial risk tolerance is relatively stable across time. The six elements comprising the behavioral loss tolerance factor tend to be highly correlated. This does not mean, however, that the elements can be used as substitutes for each other. Just as income and net worth are highly correlated, measuring, say, income and then assuming net worth based on the income assessment would be irresponsible. In this report, an investor (or her financial advisor) is responsible for evaluating each of the six elements. How the exact assessment is made is a decision the financial advisor and/or the firm must make. The risk-profiling methodology outlined in this report is assessment and product neutral. Appendix A provides an overview of the concepts needed to effectively evaluate risk-tolerance and risk-aversion questionnaires. The information in Appendix A can also be used to guide the choice of questions and questionnaires used to measure risk preference, financial knowledge, investing experience, risk perception, and risk composure. 9 David M. Cordell, “RiskPACK: How to Evaluate Risk Tolerance,” Journal of Financial Planning 14, no. 6 (June 2001): 36–40. 10 The concept of risk tolerance is related to loss tolerance/aversion. Loss tolerance relates to prospect theory and the notion that people weigh losing money more heavily than making money. When risk tolerance is viewed this way, an investor will establish a baseline portfolio value level. The investor will then tolerate swings in the market so long as the resulting portfolio balance remains above the reference point. 8 8 | CFA Institute Investment Risk Profiling Numerous commercial firms provide financial risktolerance evaluation and assessment platforms. The two most common approaches used to measure risk tolerance are psychologically derived risk-tolerance questionnaires11 and economics-based revealed preference tests.12 Appendix A provides a detailed description of the questions a financial advisor should ask before choosing a risk-tolerance questionnaire or revealed preference test for use in the risk-profiling process this report describes. Simplifying the Process Financial advisors may find that categorizing risk tolerance as follows is useful in the risk-profiling process: 1 = Very Low; 2 = Low; 3 = Moderate; 4 = High; 5 = Very High. Risk Preference Risk preference refers to an investor’s use of subjective and objective cognitive evaluations to describe her feelings regarding a real or potential course of action. For example, an investor may prefer investing in certificates of deposit based on subjective probability estimates that indicate a minimal chance of losing money; another investor may prefer to avoid certificates of deposit based on a cognitive evaluation showing that the after-tax and after-inflation returns associated with these assets result in problematic outcomes. In nearly all cases, investors prefer taking less risk.13 Keep in mind that an investor may prefer a low volatility investment or portfolio while also being willing to invest more aggressively if the returns justify the risks. Stated another way, an investor may prefer low volatility investments while concurrently exhibiting a willingness to take financial risk. Simplifying the Process Financial advisors may find that categorizing an investor’s risk preference as follows is useful in the risk-profiling process: 1 = Maximize Safety; 2 = Mostly Safety; 3 = Mix of Safety and Return; 4 = Mostly Return; 5 = Maximize Return. Financial Knowledge Financial knowledge represents the combined financial information, facts, and skills an investor exhibits and uses when making financial decisions. Financial knowledge is gained through education, training, and experience. In the context of risk profiling, an investor’s financial knowledge can be evaluated multiple ways, including via assessments a financial advisor makes after discussing broad financial topics with the investor. A more precise estimate of financial knowledge can be obtained by having an investor complete a financial knowledge quiz during the datagathering phase of the investment management process. For example, the Financial Industry Regulatory Authority (FINRA) Investor Education Foundation’s national financial capability study (www. usfinancialcapability.org/quizzes.php) has questions that can be used for this purpose.14 Simplifying the Process Financial advisors may find that categorizing an investor’s financial knowledge as follows is useful in the risk-profiling process: 1 = Not at All Knowledgeable; 2 = Minimally Knowledgeable; 3 = Moderately Knowledgeable; 4 = Competent; 5 = Very Knowledgeable. Financial advisors who are primarily interested in anticipating or predicting an investor’s future investment or financial behavior—after a recommendation has been implemented—will find behavioral prediction tools valuable. Scores from these tools provide a forecast estimate of future investor behavior during market corrections and other events. 12 These tools ask questions based on the economic concept of risk in which probability outcomes are predetermined. Resulting answers to such questions can be used to derive a measure of constant relative risk aversion. Constant relative risk aversion can then be used to estimate an investor’s utility curve. Where the utility curve intersects the efficient frontier then becomes the recommended portfolio. 13 Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (March 1952): 77–91. 14 See Annamaria Lusardi and Olivia S. Mitchell, “Baby Boomer Retirement Security: The Roles of Planning, Financial Literacy, and Housing Wealth,” Journal of Monetary Economics 54, no. 1 (January 2007): 205–224. 11 CFA Institute | 9 Investment Risk Profiling Investing Experience Investing experience refers to an investor’s mastery of financial topics and skills obtained through action, behavior, or participation in financial and/ or investment activities. The relationship between risk taking and experience is generally positive, with those who exhibit modest to high levels of experience being more likely to trade securities, purchase and hold investment assets (including real estate), and save and borrow more aggressively. Few financial experience questionnaires, scales, or measurement tools exist. Within the financial risk-profiling framework presented in this report, financial experience can be assessed using a financial advisor’s professional judgment. A key element of this assessment should be linked to the number of years the investor has been actively engaged in making financial decisions and/ or the number of investment and business cycles the investor has experienced. Simplifying the Process Financial advisors may find that categorizing an investor’s investing experience as follows is useful in the risk-profiling process: 1 = None; 2 = Very Little; 3 = Some; 4 = Modest; 5 = Extensive. with investing. Those who perceive little to no such risk should exhibit greater adaptability in the face of market volatility. Risk perception can be evaluated based on a financial advisor’s discussions with an investor or by asking an investor how she or he feels about taking financial risks (e.g., “How risky is the stock market?”). Simplifying the Process Financial advisors may find that categorizing an investor’s risk perception as follows—based on the investor’s answer to the question “How risky is the stock market?”—is useful in the risk-profiling process: 1 = Very Risky; 2 = Somewhat Risky; 3 = Neutral; 4 = Somewhat Safe; 5 = Very Safe. Risk Composure Risk composure refers to the likelihood that in a perceived or actual crisis, an investor will exhibit behavior fundamentally different from her past actions.17 Investors with low risk composure tend to act in a biased manner, which often results in actions that crystalize losses. Risk composure can be measured by evaluating an investor’s past decisions and actions. Risk Perception Simplifying the Process Risk perception refers to a judgment an investor makes (feels) regarding the severity of risk in association with the broader economic environment. Risk perception can be influenced by the media and/or an investor’s lack of knowledge and experience. How an investor perceives the degree of risk associated with a behavior is known to contribute to his engagement in risk-taking behavior.15 Risk perception is primarily a cognitive activity involving the appraisal of external conditions and internal states.16 Generally, perception of risk involves a subjective evaluation of potential risk-taking outcomes. Financial advisors may find that categorizing an investor’s risk composure as follows—based on an investor’s answer to the question “In the past, when faced with investment losses, what did you do?”— is useful in the risk-profiling process: As conceptualized in the risk-profiling process described in this report, risk perception is linked to an investor’s judgment of the riskiness associated 1 = Sold Investment (Low Risk Composure); 3 = Did Nothing (Moderate Risk Composure); 5 = Purchased More (High Risk Composure). Behavioral Loss Tolerance Summary Financial advisors should assess and evaluate each of these six elements to arrive at an estimation of an investor’s behavioral loss tolerance. Sim B. Sitkin and Amy L. Pablo, “Reconceptualizing the Determinants of Risk Behavior,” Academy of Management Review 17, no. 1 (January 1992): 9–38. 16 Michael Joseph Roszkowski and Geoff Davey, “Risk Perception and Risk Tolerance Changes Attributable to the 2008 Economic Crisis: A Subtle but Critical Difference,” Journal of Financial Service Professionals 64, no. 4 (July 2010): 42–53. 17 David M. Cordell, “RiskPACK: How to Evaluate Risk Tolerance,” Journal of Financial Planning 14, no. 6 (June 2001): 36–40. 15 10 | CFA Institute 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