Risk profile tests - Is there a gap between stated and actual risk appetite?

CLAIMS to sustainability have become commonplace in Singapore's fund management, distribution and advisory landscape. But a recent piece of research raises some intriguing questions, with wider implications beyond sustainable funds.

Capital Preferences, a firm specialising in profiling tools to help advisers better understand and guide their clients, has found in recent research that there is a significant gap between intention and action in the growing sustainable investment market. It found that 3 out of 4 investors were not confident that their current portfolios were aligned to their environmental, social and governance (ESG) values.

While the study is interesting in itself, it raises a wider and arguably more serious question: Does a similar gap exist between clients' stated risk profiles and the portfolios or investments they are put into? A risk profile assessment is routinely in the form of a set of 3 to 4 questions. It is administered at the outset prior to any investment, and its format has hardly changed over the past decade or 2.

The depth of risk profiling you encounter is also likely to vary depending on whether you engage a licensed personal adviser with whom you can have lengthy conversations, or you invest via a bank or robo adviser.

Regardless of the mode of advisory or investment, an examination of risk profiling tools is long overdue. After all, investors' worst enemies are themselves. An insightful discussion on risk tolerance - on the investor's need and capacity to take risks in order to reach long term goals - will go a long way to help advisers and clients to come to grips with the perennial tug of war between fear and greed, which often gets the best of us.

Capital Preferences' client profiling tools are rooted in decision science and behavioural economics, and delivered via fintech. These are applied to profilers for risk tolerance, saving and investment preferences, ESG preferences and goal priorities, among others.

The firm's approach draws from over 15 years of research by its co-founder and chief scientist Shachar Kariv, who is also chair of the economics department at the University of California, Berkeley. He is widely regarded as a top decision and game theorist. Dr Kariv's work focuses on "revealed preferences". This approach presents clients with scenarios through a graphical interface to discern the tradeoffs they are willing to make. This is in contrast to the most common method of profiling via "stated preferences" or a simple questionnaire.

The firm's chief marketing officer Pat Spenner says: "The revealed preferences work... using graphical interfaces to let people select a point along a spectrum that involves a trade-off and using sophisticated mathematics to model people's preferences. We first started applying that to risk preferences, and we've just launched the sustainable investing simulator this year."

As Dr Kariv himself explains in brief clips on the company's website, revealed preferences "gets (clients') hands dirty" by presenting them with scenarios of risk versus return in which they need to make a decision. This process surfaces clients' risk tolerance. "The basic idea is that action speaks louder than words," he says. The profilers are understood to be used by major wealth management firms globally, but are yet to be used in Singapore.

In a clip, Dr Kariv says mathematics is essential to arrive at a utility function; clients' risk tolerance is translated into numbers, which are mapped into portfolios. "This function is the holy grail when we can take and map it into portfolio construction algorithms. Portfolio construction is based on mathematics. If your risk tolerance is not translated into mathematics, the 2 parts of understanding your client and designing products and portfolios that will fit them don't speak to each other. If you have the risk tolerance of clients with precision... (you can) map it into portfolio construction, creating products to fit this risk tolerance."

View of risk profilers

Here is a view of risk profilers common in the market: DBS's risk profiling for investments is part of its AI-powered app NAV Planner, a series of questions including level of financial knowledge and amount of tolerable loss. DBS has said its retail clients invest on average S$3,000 a year, and those guided by the NAV Planner invest more than double that at S$7,500 a year. OCBC's risk profiler is part of its know-your-client assessment, and comprises a set of standard questions.

For robos such as Endowus, the process is quick and simple. You are asked to choose between a mid- to long-term horizon and cash management. A slider lets you select how much loss you can tolerate. Once you choose your portfolio, it models a range of historical outcomes, from which you get an idea of whether you will be able to sleep at night.

Samuel Rhee, Endowus chief investment officer, says: "The main reason (and this is philosophical) that one should do risk profiling and risk assessment for the individual investor is to make sure that the appropriate risk portfolio will allow them to stick through any volatility to achieve the outcome they desire.

"In that light, we looked at the various measures and realised after multiple feedback from clients and our own review that the single most important risk that clients worry about is the risk of losing money. Hence we use the maximum drawdown (peak to trough fall) and the 12-month rolling worst outcome (throughout all data points for 12 months) to see what is the risk of people losing money and by how much during that period.

"We match that against the asset allocation and allocate investors accordingly. It may seem simple - and in fact, it is a simple process - but it is a decision we made after long consultations and deep research about what is the best way to represent risk to the individual investor."

Providend's head of solutions Eddy Cheong says the firm approaches risk from three dimensions: the need to take risk; ability or capacity to take risk; and willingness to take risk. Questionnaires capture the willingness to take risks, but there are three other dimensions, he says.

One, multiple goals might have varying time horizons and clients also need sufficient resources to stay invested. Two, a client may have high ability to take risk, but may actually be risk-averse. Three, a client may not need to take investment risk because he has excess financial resources for long term goals.

As there are questions not easily captured by a questionnaire, a discussion with clients is key, he says. Providend is a fee-only advisory firm. "There is an important element of human interaction with advisers to understand and clarify clients' risk need, willingness and ability before giving an investment recommendation. It could involve reviewing their financial plans, insurance gaps, life stage and responsibilities as well as educating and clarifying any misperception of risk with the clients."

He adds that clients' need to take risk and capacity for risk shift over time. "We believe that we can improve the client's investment experience and their perception of risk over time... We built into our advisory process a regular reassessment of the client's risk tolerance."