investor risk profiles and portfolio strategy

11 May 2020

Investor Risk Profiles and Portfolio StrategyBob Dannhauser, CFA, FRM, CAIA

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SEBI requirements

✤ Investment adviser shall ensure that:

✤ (a) it obtains from the client, such information as is necessary for the purpose of giving investment advice, including

the following:

✤ (i) age

✤ (ii) investment objectives including time for which they wish to stay invested, the purposes of the investment

✤ (iii) income details

✤ (iv) existing investments/assets

✤ (v) risk appetite/tolerance

✤ (vi) liability/borrowing details

Source: SEBI (Investment Advisers) Regulations 2013 https://www.sebi.gov.in/legal/regulations/jan-2013/sebi-investment-advisers-regulations-2013-last-

amended-on-december-08-2016-_34619.html3

SEBI requirements

✤ (b) it has a process for assessing the risk a client is willing and able to take, including:

✤ (i) assessing a client’s capacity for absorbing loss;

✤ (ii) identifying whether client is unwilling or unable to accept the risk of loss of capital;

✤ (iii) appropriately interpreting client responses to questions and not attributing

inappropriate weight to certain answers;

✤ (c) where tools are used for risk profiling, it should be ensured that the tools are fit for

the purpose and any limitations are identified and mitigated



SEBI requirements

✤ (d) any questions or description in any questionnaires used to establish the risk a client

is willing and able to take are fair, clear, and not misleading, and should ensure that:

✤ (i) questionnaire is not vague or use double negatives or in a complex language that

the client may not understand;

✤ (ii) questionnaire is not structured in a way that it contains leading questions

✤ (e) risk profile is communicated to the client after risk assessment is done

✤ (f) information provided by clients and their risk assessment is updated periodically



“People are ‘rational’ in standard finance; they are ‘normal’ in behavioral finance.

Rational people care about utilitarian characteristics but not value-expressive

ones, are never confused by cognitive errors, have perfect self-control, are always

averse to risk, and are never averse to regret. Normal people do not obediently

follow that pattern.”

–Meir Statman (1999)

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What do advisors actually do?

Professional Judgment

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What do advisors actually do?

“A global study of over 200 professional financial advisors is undertaken to

test how risk profile factors are used to make investment portfolio allocation

recommendations. When presented with identical risk profile information,

similar to what a competent financial advisor would normally collect from a

prospective client, respondents are asked to recommend a portfolio allocation

among equity, fixed income, and cash for five hypothetical client scenarios.

The results find that financial advisors, using their professional

judgment, inconsistently puzzled together the presented risk profile

factors into portfolio recommendations, on average doing little more than

applying the heuristic 100-minus-age rule to recommendations…”

8Amy Hubble, John E. Grable. “The Efficient Frontuzzle: What Investment Risk Profiling Still Fails To Solve

The Journal of Investing Sep 2019, 28 (6) 73-90; DOI: 10.3905/joi.2019.1.098

What should advisors do?

✤ Measure and reconcile three dimensions of investment risk profile

1. Risk Need

2. Risk-taking Ability

3. Behavioral Loss Tolerance

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Behavioral Loss Tolerance

1. Risk tolerance

2. Risk preference

3. Financial knowledge

4. Investing experience

5. Risk perception

6. Risk composure10

Assessing Validity and Reliability

✤ Validity - how accurate the tool is in describing or predicting attitudes or

behavior

✤ Content validity

✤ Criterion validity (concurrent and predictive)

✤ Reliability - how well the test generates the same results when the same

person takes it in the same setting

✤ Cronbach’s alpha (> 0.70) common but subject to some criticism11

Red flags in assessment instruments

✤ Questions outside the context of investment risk taking

✤ Questions make investors anticipate their future behavior

✤ Questions pose 50/50 chance outcomes

✤ Questions are leading

✤ Questions use complex language (or are written for CFA charterholders!)

✤ Questions are too ambitious/doublebarreled

✤ Too few questions

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✤ Three dimensions of investment risk profile: measure and reconcile

1. Risk Need



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Assessing Risk-taking Ability

✤ Goal time horizons

✤ Need for liquidity

✤ Risk capacity

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✤ Three dimensions of investment risk profile: measure and reconcile

1. Risk Need



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Establishing Investor’s Risk Need

✤ Determine required rate of return for achievement of goals

✤ Relate current assets and PV of cash flows to PV of liabilities (goals)

✤ Consider market risk environment (i.e. is the required rate of return

realistic?)

✤ Consider consequence of failure to achieve goal

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Reconciling the 3 dimensions to create Portfolio

Strategy

✤ Risk need can’t exceed risk-taking ability for a goal

✤ Lower risk need can be discounted when ability and tolerance are high

✤ High tolerance can be discounted when need and ability are low

✤ Low tolerance can’t be ignored - but might be coachable if need and ability are

high

✤ Risk-taking ability is an upper bound on portfolio volatility - but it changes over

time and needs reassessment17

Reflecting the Risk Profile Discovery process in

the IPS

✤ The Investment Policy Statement (IPS) is a useful place to memorialize key

dimensions of the investor risk profile that informs your portfolio strategy

✤ Document the objective dimensions (risk need, risk-taking ability)

✤ Acknowledge/Characterize behavioral loss tolerance

✤ The “Achievement Policy Statement” can document decumulation planning

and reflect the investor risk profile, especially risk-taking ability

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Client Risk Profiling Shouldn’t Be A Black Box

✤ Thoughtful compliance that actually improves the end product

✤ “Rehearse Disaster” in client communications and reviews

✤ Differentiate the value of your professional judgment

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Read More About It

✤ CFA Institute: “Investment Risk Profiling: A Guide For Financial Advisors”

https://www.cfainstitute.org/-/media/documents/survey/investment-risk-

profiling.ashx or Google “CFA Risk Profiling Dannhauser”

✤ The Journal Of Investing: “The Efficient Frontuzzle: What Investment Risk

Profiling Still Fails To Solve. https://joi.pm-

research.com/content/early/2019/07/27/joi.2019.1.098

Thanks for your attention and attendance! [email protected] @robdnn

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https://www.cfainstitute.org/-/media/documents/survey/investment-risk-profiling.ashx

https://joi.pm-research.com/content/early/2019/07/27/joi.2019.1.098

mailto:[email protected]

investor risk profiles and portfolio strategy

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