This process will probably be using some sort of questionnaire to obtain a starting point for a client’s attitude to risk.
This should then lead to a discussion about the potential investment outcomes and associated risks. The client’s capacity for loss should also be captured at this time.
At the end of the above process, it is likely that the client and adviser will have settled on a specific risk profile, probably between one and 10 (other ranges are available).
Challenge
The next challenge is to identify an investment solution that matches that profile and, if opting for a ‘one and done’ solution, then it’s absolutely vital that the risk profile and the risk rating of the solution are aligned.
There are many risk profiling tools in the marketplace but they all have very different risk characteristics, even if they appear similar, with, say 10 risk levels.
However these levels will use very different risk boundaries, usually defined using annualised volatility bands.
Let’s look at a hypothetical example of two risk profilers and their volatility boundaries for their risk profile 5s:
| Lower Volatility Boundary | Upper Volatility Boundary | |
| Risk Profiler A | 8% | 10% |
| Risk Profiler B | 10% | 12% |
If the adviser were using ‘A’, then a suitable fund would have to be risk rated with an expected annualised volatility of between 8 per cent and 10 per cent, which would be in line with ‘5’ for that profiler.
However, if the adviser were using ‘B’ then the same fund would not be volatile enough for ‘5’, as the expected annualised volatility needs to be 10 per cent or more to equal a ‘5’, so in that case the same fund would probably be rated as a ‘4’.
So, it is clear from this basic comparison that fund risk ratings and risk profilers cannot be mixed and suitable funds must use the same rating basis as the actual risk profiling tool.
Aligning risk
If we then think about aligning risk profiles to adviser portfolios (the ‘fund picking’ approach), then there are some different challenges.
Most risk profiling tools will produce a range of optimised asset allocations that the providers believe will produce outcomes in line with the risk and return characteristics of their risk profiles, based on various market assumptions.
For example the Defaqto Engage Risk Profiling Tool currently uses the following optimised asset allocation for a risk profile 5 portfolio:
But, again, because all risk profilers are different the optimised asset allocations are also different.
Let’s look at two different providers' asset allocation models, both of which are available in the marketplace, for a risk profile 5.
Asset Class | A | B |
| UK Government Bonds | 5% | 42% |
| UK Corporate Bonds | 23% | |
| Global (ex-UK) Fixed Income | 6% | 10% |
| Commodities | 5% | - |
| Global Property | 15% | 10% |
| UK Equity | 10% | 14% |
| Europe (ex-UK) Equity | 12% | 5% |
| North America Equity | 20% | 8% |
| Dev’d Pacific (ex-Japan) Equity | 4% | - |
| Dev’d Pacific (inc-Japan) Equity | - | 5% |
| Emerging Market Equity | - | 5% |
Both are looking to produce a risk profile 5 experience for clients but one splits out the UK Fixed Interest, has a much higher allocation to non-UK equities and allocates to commodities.
