The use of risk-rated or target risk is worrying because a single fund mapped to the output of a risk questionnaire potentially bypasses any need for serious investor engagement. When a risk-rated fund is recommended, account cannot easily be taken of specific objectives or the investor’s risk exposure from existing investments held.
A further problem is that the volatility of annual investment returns is the way the industry typically chooses to categorise the riskiness of the investment funds it offers. Annual volatility has no relevance to an investor’s objectives (for example, retirement in 20 years’ time). Essentially the investment industry has no common language to relate investor objectives to investment solutions. The result of this breakdown in communication is, unsurprisingly, frequent disappointment on the part of investors followed all too regularly by claims for compensation.
There is no doubt that the widespread use by advisers of investment of risk questionnaires is a positive development in helping to ensure that investment recommendations recognise their clients’ attitude to investment risk. However the score from a statistically validated risk questionnaire does not say anything about their clients’ investment objectives or anything directly about his personal circumstances.
The risk profile from the questionnaire provides a starting point for an informed discussion about the risks associated with investors’ objectives and the investment outcomes that might be achieved. The danger is that, because of the sophistication of a good risk questionnaire, advisers rely on it to do more than it has been designed to do.
Bruce Moss is strategy director of eValue
Key points
One well known and widely used risk questionnaire had to be withdrawn completely as a result of an FSA review.
Much work has been done by behavioural finance academics on people’s attitude to making investment decisions.
Stochastic modelling offers a unique way of ensuring that investors are fully engaged and can ensure consistency between risk tolerance and the recommended investment solutions.
