Sunday, June 30, 2013

Evaluation of Client Risk Profile – Part II /II (Risk Tolerance)

In order to evaluate which risk to take, when investing his funds a client needs to be aware of his risk ability and of his risk tolerance. It’s a very important part of an investment advisors job to help the client on this subject


Risk Tolerance
The risk tolerance defines how a client deals emotionally with investment risks. Although a client could easily afford to lose 50 % of his fortune due to high regular income, it is possible that dropping stock markets, which cause an unrealized loss of 10% on client’s investments could make him freak out. In the worst case the client wants to sell his position and realize the loss. Although the advice was good and long-term would have generated a high profit it is a fail. The client has realized the loss and probably will never ever touch these investments again. Therefore recognizing client’s risk tolerance is key.
Compared to the evaluation of risk ability, where basically current holdings need to be analyzed and future funds in- and outflows need to be evaluated, finding out on risk tolerance is significantly more difficult. Below three approaches to evaluate clients risk tolerance:
Personal Unstructured Conversation with the Client Investment advisor explains the client the potential products to invest in. He explains how they work and what risk they involve and how much money the client could win in the best or lose in the worst case. He lets the client talk and asks ad-hoc questions in order to find out more on risk tolerance. This approach requires a very experienced investment advisor. It was a common approach 10 to 20 years ago.
Risk Profile Questionnaire
This is a structured standardized approach, which allows to ensure a stable standard when evaluating client’s risk tolerance. The client has to fill in a questionnaire on paper or even better, electronically. The questionnaire usually consists of 30 to 40 questions. These questions cover areas such as: Current situation, familiarity with investment matters and time horizon. An important part are the examples such as “Your investment fell by more than 10% over a short period. What would you do? Sell all, sell a portion, hold or invest more funds”
Back Tracking
In this case based on conversation with the client the investment advisor is proposing an asset allocation and an selection of assets. Then the system calculates for exactly this proposal, what would have happened based on the market developments of the past 10 years. What was the maximal drop in one week/one month? What was the longest underwater period (period during which the investment is trading for less than the purchase price) etc. Personally I prefer this approach. The challenge is the huge number of data needed and therefore the required IT capacity.

Saturday, June 15, 2013

Evaluation of Client Risk Profile – Part I /II (Risk Ability)


One of the key elements to ensure client satisfaction is to recognize what risk an investment client is willing to take and what he is emotionally able to deal with. If the content of a portfolio matches with the client’s risk profile, he will stay calm even in case of minus performance.  On the other hand, if investments are not corresponding with the risk the client is willing and able to take, even a positive performance will not lead to full satisfaction.


Risk Ability

It defines the client’s ability to cope with financial losses, without a noticeable effect on his standard of living. Evaluating client’s risk ability is the easier part. 

 The client advisor needs to analyze the client’s current holdings and future inflows and outflows.
  • What is the size and the asset type
  • What inflow will be generated based on client’s holdings such earnings on dividends/interest
  • What is his monthly salary
  • Are there any future inflows to be expected, such as inheritances etc.
  • What will be his future financial obligations, such as interest payments & redemption of loans
  • What are his living costs, regular payments, tax payments etc.
An important factor is to channel all this information and above all to visualize it. Like this the client advisor can ensure, that the client does not forget to provide important information. In order to provide the best possible personalized investment solution, it is important that this visualization reflects the clients overall situation. Whenever possible the advisor should therefore try to find out about holdings the investment client has with other banks.
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