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INVESTOR RISK PROFILING:

AN OVERVIEW
• Suitability rules demand that practitioners assess the risk
profiles of investors before recommending specific investment
products or strategies.
• Current practice of using questionnaires to identify investor risk
profiles is inadequate and unreliable, typically explaining less
than 15% of the variation in risky assets between investors.
• Research has identified more reliable ways to assess investor
risk profiles, such as addressing the environment of an investor
as well as her lifetime experiences.
• Identifiable factors can be combined to build reliable risk
profiles—something that is increasingly demanded by regulators.

Joachim Klement, CFA

ISBN 978-1-934667-93-4
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INVESTOR RISK PROFILING:
AN OVERVIEW

Joachim klement, CfA

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ISBN 978-1-934667-93-4
April 2015
CONTENTS
Summary. . ..............................................................................................................1
Introduction...........................................................................................................1
What Is a Risk Profile?.............................................................................................2
Current Practice. . ....................................................................................................5
Recent Findings about True Influences on Investor Portfolios.. ...........................10
Practical Guidelines for Practitioners...................................................................13
Summary and Outlook. . .......................................................................................15
References. . ..........................................................................................................17
Investor Risk Profiling:
An Overview
Joachim Klement, CFA
Chief Investment Officer
Wellershoff & Partners Ltd.

SUMMARY
In this discussion of investor risk profiling, current risk-profiling practice is
reviewed and contrasted with regulatory demands and recent research findings.
The current standard process of risk profiling through questionnaires is found to
be highly unreliable and typically explains less than 15% of the variation in risky
assets between investors. The cause is primarily the design of the questionnaires,
which focus on socioeconomic variables and hypothetical scenarios to elicit the
investor’s behavior.

Existing research in risk profiling shows, however, that several different factors
can provide more accurate and reliable insight into the risk profiles of inves-
tors. Among these factors are the lifetime experiences of the investor and the
financial decisions the investor has made in the past. Another important factor is
the influence of family, friends, and advisers. These factors can be identified and
used by practitioners to enhance their understanding of client preferences and
inform their recommendations of investment strategies and products.

INTRODUCTION
Investor risk profiling is at the heart of private wealth management. In theory,
without proper knowledge of the investor’s goals, time horizon, liquidity needs,
and risk aversion, it is impossible to recommend suitable investments or build effi-
cient long-term investment strategies for that investor. Even worse, if an adviser is
not aware of the investor’s risk profile, chances are the investor will buy products
that help the adviser sleep well at night rather than the other way around.

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 Investor Risk Profiling

To help ensure that consumers are sold only products that are suitable for them,
every major developed financial market has instituted suitability rules. In the
European Union, Article 25 of the Markets in Financial Instruments Directive II
(MiFID II) provides guidance on suitability; in the United States, Rule 2111 of the
Financial Industry Regulatory Authority (FINRA) deals with this issue.

Despite the central role of risk profiling in current investor-servicing processes,

what constitutes an adequate, accurate risk profile—and a suitable investment
based on it—remains an open question. Practitioners, regulators, and academics
agree that suitability depends primarily on the characteristics of the investor, not
the product itself (Davies and Brooks 2014).

Typically, practitioners and regulators use “risk profile” as a blanket term to

describe the various facts and investor traits that need to be taken into account to
identify suitable investments for an investor. Of course, the devil is in the details,
because exactly which facts and traits determine the risk profile of an investor
is a matter of opinion, and current research does not give a definitive answer.
Moreover, findings from behavioral research fundamentally challenge some of
the assumptions that current practice and suitability regulations are based on.

WHAT IS A RISK PROFILE?

Apple founder Steve Jobs, when asked in a mid-career interview about the rea-
sons for his success, presciently answered that almost no one in business really
asks why things are done the way that they are (Gau, Segaller, and Sen 2012). In
this vein, this discussion begins with two fundamental questions. First, what is
an investor risk profile currently understood to be? Second, what are the most
common risk-profiling techniques used by practitioners?

Traditional finance uses the concepts of classical decision making, modern port-
folio theory, and the capital asset pricing model (CAPM) to define the risk pro-
file of an investor. In this model, investors are inherently risk averse and take on
additional risk only if they judge that higher anticipated returns will compensate
them for it. One of the fundamental results of modern portfolio theory is that,
under the assumptions of the CAPM (Sharpe 1964), all investors invest in a com-
bination of the risk-free asset and the market portfolio. The allocation of funds

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 Investor Risk Profiling

between the risk-free asset and the risky market portfolio is determined only by
the risk aversion of the investor. Thus, in the world described by this traditional
model, the investor’s risk profile is given by the risk aversion factor in the utility
function of the investor.

In reality, investors face constraints and do not act according to the model of
rationality used in traditional finance (see, for example, Kahnemann 2012). A use-
ful approach to dealing with these practical challenges is to distinguish between
risk capacity and risk aversion.

Risk capacity applies to the objective ability of an investor to take on financial

risk. Capacity depends on objective economic circumstances, such as the inves-
tor’s investment horizon, liquidity needs, income, and wealth, as well as tax rates
and other factors. The primary distinguishing feature of risk capacity is that it
is relatively immune to psychological distortion or subjective perception. Risk
aversion, however, may be understood as the combination of psychological
traits and emotional responses that determine the investor’s willingness to take
on financial risk and the degree of psychological or emotional pain the inves-
tor experiences when faced with financial loss. These emotional factors are often
even more important for practitioners to understand than the objective eco-
nomic circumstances of the investor; yet, they are harder to measure.

Behavioral finance research has uncovered many systematic departures in inves-

tor decision making from the ideal of rationality used in traditional finance. For
example, investors tend to exhibit loss aversion, insofar as the gain in utility from
an increase in wealth is smaller in absolute value than the loss in utility from an
equally large decrease in wealth. Although these systematic deviations from
ra­tional behavior have been widely documented, the challenge for practitioners is
to identify to what degree a given investor deviates from idealized rational behav-
ior, when the person does so, and—perhaps most consequentially—whether the
practitioner can assist the investor toward optimal investment outcomes.

The combination of risk capacity and risk aversion constitutes what the finance
industry calls the investor “risk profile.” Investments are deemed suitable for the
investor only if the investments’ risks fall within the limits of the individual’s risk
capacity and risk aversion. Unfortunately, we as yet have no generally accepted

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 Investor Risk Profiling

list of objective economic circumstances that define risk capacity and even less,
a list of psychological traits that define risk aversion.

Nevertheless, regulators require investment firms to establish investor risk pro-

files before recommending any financial products or investments for those
investors. The rationale is that the “buyer beware” philosophy has hurt too many
investors in the past. The prevailing regulatory desire is to put at least minimal
investor protections in place. Current regulations reflect the complexity sur-
rounding risk profiling, with many generally vague as to what factors influence a
risk profile. Current regulatory guidance also differs among countries.

Article 25 of the MiFID II states,

When providing investment advice or portfolio management, the

investment firm shall obtain the necessary information regarding the
client’s . . . knowledge and experience in the investment field relevant
to the specific type of product, that person’s financial situation includ-
ing his ability to bear losses, and his investment objectives including
his risk tolerance.

In the United States, FINRA Rule 2111 states,

A customer’s investment profile includes, but is not limited to, the

customer’s age, other investments, financial situation and needs, tax
status, investment objectives, investment experience, investment
time horizon, liquidity needs, risk tolerance, and any other informa-
tion the customer may disclose to the member or associated person
in connection with such recommendation.

Risk tolerance features prominently in both regulations, but neither one says
how to measure it or how it influences the range of suitable investments. The list
of financial circumstances influencing the investor’s risk profile is lengthy in the
case of the FINRA regulation but not defined at all in the European regulation.
The European regulation requires assessment of the experience and knowledge
of the investor in the relevant investment field, whereas US regulations demand
only an assessment of the general investment experience of the investor. It is
fair to say that the lack of clear, consistent guidance by regulators leaves practi-
tioners hanging in midair. They must ensure compliance yet lack clarity on what

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 Investor Risk Profiling

constitutes compliance. They also do not know what kind of risk profiling actu-
ally leads to investor protection and acceptable outcomes for the practitioner.

The result is a myriad of approaches to risk profiling and little evidence that these
techniques meet any of their intended functions.

CURRENT PRACTICE
The typical investor risk-profiling process is shown in Figure 1. The task usually
begins with definition and discussion of the investor’s situation and the goal(s)
that are to be achieved by the investments or portfolio. Serious issues arise at
this point: Investors may have multiple goals, they may never have considered or
articulated their objectives in this way, and they are not necessarily able to cap-
ture goals in terms of quantity or time. A common multiple-goal situation is
posed by an investor who wants to save for retirement, which she expects in 10
years, while also wanting to save for a down payment on a new house. To com-
plicate the situation further, she may also want to put aside a pool of liquid assets
(emergency funds) that enable her to sleep well at night. What financial invest-
ment will achieve this last goal may be hard to define.

FIGURE 1. STANDARD PROCESS FOR RISK PROFILING

Define goals

Fill out risk profile

questionnaire

Score
questionnaire

Determine asset
allocation

Implement

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 Investor Risk Profiling

If we assume for the moment that the goals of the investor can be adequately
defined, the process moves to filling out a questionnaire intended to quantify
and document the risk aversion and risk capacity of the investor. At this stage,
problems mushroom: In theory, to provide meaningful and reliable results, ques-
tionnaires need to be properly validated and tested. Validation and testing, how-
ever, are apparently seldom done.
Rice (2005) analyzed 131 questionnaires from investment firms and advisers in
the United States, and his findings are troubling, to say the least. The number
of questions used in the questionnaires ranged from 1 to 49. Probably the most
troublesome finding is that 11% of the questionnaires he analyzed explicitly
asked the investor to select a specific risk profile or portfolio. One has to wonder
what use a questionnaire is if it asks the investor to provide the result of the risk-
profiling analysis.
Even for more sophisticated questionnaires, however, the design is hardly robust.
Although 65% of questionnaires had at least one question about the investor’s
time horizon, 35% did not ask about the time horizon at all. Some 70% of ques-
tionnaires asked about the investor’s anticipated behavior in various market cir-
cumstances, but the treatment was superficial and never related to the investor’s
own financial situation. Yet, putting a scenario into a context relevant for the
individual investor is important; a financial loss of $10,000 might be devastating
to a student but not relevant to a millionaire. To truly assess the emotional reac-
tion that a financial loss might trigger, the size of the loss has to be meaningful
to the investor, and to evoke an emotional response, it has to be made relevant.
The influence of framing on the outcome of financial decisions has long been
established (Tversky and Kahnemann 1981). Thus, hypothetical scenarios in
questionnaires should be framed in meaningful ways for an individual investor—
something that is hard to accomplish in paper-based questionnaires. To demon-
strate the impact of framing on the outcome of risk-profiling questionnaires, I
recruited 489 individuals through Amazon’s MTurk service. Each individual was
randomly assigned to one of three simple risk questionnaires for which they had
to answer a few personal questions—age, gender, income, and education—as
well as four scenario questions of the following form:

•• Version 1: Assume you invest half your savings in stock A. After one month,
the investment has declined by 10%. What do you do? Buy some more, do
nothing, or sell?

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 Investor Risk Profiling

•• Version 2: Assume you invest $100 into stock A. After one month, the
investment has declined by $10. What do you do? Buy some more, do noth-
ing, or sell?

•• Version 3: Assume you invest $10 million into stock A. After one month, the
investment has declined by $1 million. What do you do? Buy some more, do
nothing, or sell?

Questions were asked for a decline of 10%, 30%, and 50% as well as an increase of
10% in the stock price. Figure 2 shows the percentage of respondents who chose
to sell their stock holdings depending on the amount lost or gained. The differ-
ences between the three versions of the questionnaire are statistically significant.

In a more thorough analysis, I estimated ordered logistic regressions to assess

whether the decision to sell stocks or buy some more was indeed triggered by
the different frames of representation.

FIGURE 2. PERCENTAGE OF INVESTORS WHO DECIDED TO

SELL IN THE HYPOTHETICAL SCENARIOS
Percent
60

50

40

30

20

10

0
10 –10 –30 –50
Gain or Loss (%)
Percentage Frame Million Dollar Frame Hundred Dollar Frame

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 Investor Risk Profiling

When differences in age, gender, income, and education of the respondents

were taken into account, the $1 million frame (Version 3 in the experiment)
led to a significant increase in the propensity to sell and a decrease in the pro-
pensity to buy some more. The differences between the $100 frame (Version 2)
and the percentage frame (Version 1) became no longer statistically significant
when the differences in age, income, and so on, of the respondents were taken
into account. For all the respondents in the
experiment, a loss or gain of $1 million was
a vast sum of money whereas $100 was typ-
The current practice of risk
ically a small amount. questionnaires is thus likely
When dealing with large stakes—even if it
underestimating the risk
is just on paper—the emotional reaction aversion of investors.
to losses is bigger than when dealing with
small sums or abstract sums, such as percentage losses. This increased emotional
reaction increases loss aversion. The percentage of respondents choosing to sell
in the $1 million frame is typically about one third higher than in the percent-
age frame. Unfortunately, the questionnaires analyzed by Rice (2005) all framed
scenarios in terms of percentages or small money amounts. The current practice
of risk questionnaires is thus likely underestimating the risk aversion of inves-
tors. When faced with a generic paper questionnaire, we might all be risk-loving
investors, but when the next financial crisis hits, actual behavior might be very
different from what we said we would do when answering a questionnaire.

Once the questionnaire has been completed by the investor, the answers are then
typically scored by the adviser/investment firm and matched with a specific asset
allocation. In his survey of business practices, Rice (2005) found that scoring and
mapping are done in highly subjective ways. Scoring was generally done on an
equal-weight basis, even though some questions might have been clearly more
important in determining the risk profile than others. Similarly, the confidence an
investor had in specific answers was ignored in every instance, even though the
abstract nature of the questions might lead to large variations in confidence levels.
Finally, the determination of the resulting asset allocation seems to be typically
done in such a way as to benefit the investment firm rather than the investor.

When all questions in the questionnaires surveyed by Rice (2005) were answered
in the most conservative way, the allocation to equities ranged from 0% to 70%.

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 Investor Risk Profiling

The influence of the adviser is greater than most investors (or regulators, for that
matter) realize, as shown by Foerster, Linnainmaa, Melzer, and Previtero (2014)
in an analysis of more than 180,000 Canadian brokerage accounts. They found
that standard regressions that took into account risk tolerance (as indicated
by answers to simple hypothetical questions), investor time horizon, financial
knowledge, income, net worth, age, gender, and occupation could explain only
13.1% of the variation in the share of risky assets in investor portfolios. When the
influence of the adviser was taken into account, the share of variation in risky
assets that could be explained rose to 31.6%. In other words, the adviser turned
out to be a more influential factor in the makeup of investor portfolios than the
factors typically evaluated in a risk-profiling questionnaire. Similar results were
obtained for the home bias in investor portfolios.

In summary, increasing evidence indicates that the current practice of using

questionnaires to determine investor risk profiles is of limited reliability. The
variation in risky assets in investor portfolios explained by variables such as age,
gender, time horizon, and risk aversion is in the range of 5% to 15%, leaving the
majority of the variation unexplained.

It is surprising that this lack of reliability has not attracted more attention by
academics, regulators, or practitioners. But—to paraphrase Benny Hill—just
because nobody complains doesn’t mean that all parachutes are reliable. The
number of complaints about the sale of unsuitable investments filed with the
ombudsmen in Europe or the United States is staggering. The UK Financial
Ombudsman Service recorded 2,079 complaints in relation to stock broking
and portfolio management, with suitability questions being the main cause of
problems (Financial Ombudsman Service 2014). The office of the Ombudsman
at FINRA counted 1,283 complaints about allegedly unsuitable investments
between January 2014 and November 2014 (FINRA 2014).

To be sure, the number of complaints is down from the years after the 2007–08
financial crisis, when complaints in the United Kingdom hit 2,474 and in the
United States, hit an all-time high of 2,473 (FINRA 2011). Evidently, as long as
the investments make money for the investors, suitability issues are not noticed
or ignored. Once markets start to shake, the fragile foundations of investment
advice as practiced today start to give way.

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 Investor Risk Profiling

RECENT FINDINGS ABOUT TRUE

INFLUENCES ON INVESTOR
PORTFOLIOS
If the questions in the widely used approach of questionnaires do not explain
the majority of variation in risky assets between investor portfolios, what factors
do explain these differences? And can we use these factors to build more accu-
rate risk profiles than questionnaires provide?

A growing body of research shows that the biggest impact on our risk prefer-
ences comes from our experiences and the environment we interact with (e.g.,
Klement and Miranda 2012). Basically, the factors influencing investor risk pro-
files can be placed in three categories:

1. Our genetic predisposition to take on financial risks.

2. The people we interact with and their influence on our views.

3. The circumstances we experience in our lifetimes—in particular, during the

period psychologists call the formative years.

The risks we are genetically predisposed to take include financial risk. Although
this fact is unsurprising, the degree of influence exerted by nature may be sur-
prising. In a study of more than 37,000 identical and fraternal twins in Sweden,
Barnea, Cronqvist, and Siegel (2010) investigated the pair’s participation rate in
stock markets and the shares of risky assets in the portfolios of the individual
investors. (Sweden provides fertile hunting ground for research on the heritabil-
ity of personal traits because the Swedish Twin Registry provides comprehensive
data on all twins born in Sweden since 1886. In particular, the registry provides
data on the rare cases when identical twins were adopted by two different
sets of parents and reared in different environments.) Comparing the portfolio
choices of identical twins and fraternal twins raised in the same household and
comparing the portfolio choices of twins reared apart allowed the researchers to
differentiate between environmental and genetic influences on risk preferences.
Because Sweden also collects a lot of data on the individual portfolios of citizens
for tax purposes, the researchers could combine the Swedish Twin Registry data

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 Investor Risk Profiling

with portfolio data from the Swedish Tax Agency to carry out a useful analysis
of the risk preferences of a large pool of individual investors. Barnea et al. (2010)
showed that 20%–40% of the variation in equities in investor portfolios could be
explained by the individual’s genetic predisposition to take on financial risk.

Similar results were found by an independent study of the pension fund invest-
ments of Swedish citizens by Cesarini, Johannesson, Lichtenstein, Sandewall,
and Wallace (2010). Moreover, research has identified genomes that are linked to
financial risk taking (Dreber, Apicella, Eisenberg, Garcia, and Zamore 2009; Kuhnen
and Chiao 2009). Identifying a genetic predisposition to take financial risk is dif-
ficult for practitioners—even more so would be taking saliva samples to advise
investors based on DNA. Practitioners may have some indirect ways, however, to
examine the genetic predisposition to take or avoid risks, as discussed below.

Even if 20%–40% of the amount of financial risk investors take can be explained
by genetic traits, the majority of variation is still unexplained. Here, the influ-
ences of our environment and the people we interact with come into play. As
previously mentioned, the study by Foerster et al. (2014) showed that advisers
have a bigger impact on the portfolios of investors than do measured risk aver-
sion, age, income, and other variables. In addition, Hong, Kubik, and Stein (2004)
found that the community we live in or the church we attend plays a similarly
important role.

Another study confirmed the community effect; moving into a community with
10 percentage points higher stock market participation increases an individual’s
probability of stock ownership by about 4 percentage points (Brown, Ivkovic,
Smith, and Weisbenner 2007).

Social interactions may also be at the heart of the cultural differences found in
some studies. In a study of investors in 45 countries, Wang, Rieger, and Hens
(2011) showed that the propensity to invest over time horizons of one month to
one year differ significantly from country to country.

People living in countries that are less politically stable or that have a lower
level of social cohesion, such as Russia, Romania, and Greece, generally showed
a lower tendency to invest for the long term and a higher preference for quick
gains. At the other end of the spectrum are citizens of Germany, Switzerland, and

11
 Investor Risk Profiling

the Scandinavian countries, who showed a high propensity to invest for the long
term. Such cultural differences may have many origins and correlate with many
variables, but their influence is important and warrants study at a later time.

Finally, life experiences are an important—if not the most important—contributor

to financial risk preferences. In a groundbreaking study, Malmendier and Nagel
(2011) showed that individuals who experienced the Great Depression during
their early childhood displayed significantly different investment behavior from
those who did not—even as many as 40 years
later. Individuals who experienced the Great
Depression were less likely to invest in the stock
Life experiences are
market and held, on average, a lower allocation to an important—if not
stocks than individuals who were born and raised the most important—
in the relatively benign world after World War II. A
study by Ehrmann and Tzamourani (2012) showed
contributor to financial
that the high-inflation period of the 1970s also risk preferences.
had a lasting impact on investors.

Even 10 years after that inflation ended, investors who actively experienced the
period were more concerned about inflation than younger investors who had
not experienced that time.

A particularly important time for the formation of risk preferences is the period
between ages 16 and 25. In this period, most individuals form their beliefs
about the world, society, and life in general (Giuliano and Spilimbergo 2009).
This period often coincides with, or just precedes, many people’s first forays into
investments. Thus, the experiences of individuals during this crucial time period
influence their investment beliefs and their risk profiles for a long time. Giuliano
and Spilimbergo showed that individuals who experienced at least one reces-
sion during their formative years exhibited political and economic views later
in life that were different from those who did not. For example, these individu-
als were more prone to believe in the necessity of government intervention to
redistribute wealth from the haves to the have-nots. Massa and Simonov (2011)
investigated the interaction between financial risk taking and formative years’
experiences directly by examining the investment portfolios of individuals dur-
ing their university years. They found that when and where individuals attended
college was highly influential on the portfolios they invested in.

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 Investor Risk Profiling

The 2007–08 financial crisis provided researchers ample opportunity to study

financial risk taking in real time. Emotions ran high during the crisis, and
investors—and many advisers—experienced a disproportionate amount of
stress. Thus, the financial crisis allowed researchers to investigate whether risk
profiles are stable over time or whether, and if so, how, they are influenced by
adverse market events. These studies found that risk profiles may well consist
of a component that is stable over time and describes our general propensity to
take on risk but also a variable component that is influenced by our emotions.

The “risk as feelings” effect (Loewenstein, Weber, Hsee, and Welch 2001) predicts
that individuals make quick decisions about risks that are guided primarily by
their emotions or intuition rather than rational considerations. Burns, Peters, and
Slovic (2012) and Weber, Weber, and Nosic (2013) supported this hypothesis.
Both studies used questionnaires to identify risk preferences and actual invest-
ment behavior throughout the financial crisis. The stable component of a risk
profile seems to be the individual’s assessment of his or her risk aversion; that is,
the individual remains similarly risk averse throughout a stressful financial epi-
sode. What changes is the perception of riskiness. Once a decline has started, stock
markets are perceived as riskier than they were, and only once they recover does
the perception of riskiness decline. Thus, after a market downturn, investors are
less willing to invest in stock markets than after a recovery or a prolonged bull
market. How these perceptions of risk change over time and how the changing
perceptions dynamically influence the risk profile demands further investigation
at a later date.

PRACTICAL GUIDELINES FOR

PRACTITIONERS
Practitioners need to be aware of these research findings, but perhaps more cru-
cial is that they be able to identify the combination of traits and biases in each indi-
vidual. Using generalizations based on the research cited here is not going to be
helpful. It could, if a generalization may be allowed here, do more harm than good.

Psychometric testing is both an art and a science (which should be explored at

a later time), but practitioners can use some simple techniques to identify indi-
vidual traits more reliably than by using standardized questionnaires.

13
 Investor Risk Profiling

FINANCIAL ANAMNESIS
Doctors know that certain forms of cancer and other diseases have a significant
genetic component. To identify patients who are at risk of contracting such dis-
eases, they perform an anamnesis of the patient by asking for the medical history
of not only the patient but also parents, siblings, and other relatives. Practitioners
can engage in financial anamnesis to identify a systematic bias for or against finan-
cial risk taking by asking about the investment behavior of relatives. For example,
studies show that children of entrepreneurs are more likely to become entrepre-
neurs themselves (e.g., Heaton and Lucas 2000). Similarly, stock market participa-
tion and other parental attitudes about the riskiness of stocks seem to correlate
with attitudes of their children (Charles and Hurst 2003). So, asking about the
financial habits of relatives can shed light on the risk profile of an individual.

INVESTMENT DIARIES
Of course, nothing conveys the truth more than the actual investment behav-
ior of an investor. What an investor chooses to invest in and how the investor
decides to buy or sell is more informative of risk attitudes than a questionnaire
can be. Thus, advisers should investigate the past investment history of an indi-
vidual. The ideal instrument to do this is an investment diary in which an inves-
tor records, in real time, transactions made and the reasons for the transactions.
Over time, this investment diary paints a picture of the individual risk-taking
traits of the investor. Few investors, however, systematically record their deci-
sions in a diary, and few advisers encourage their clients to do so. In the absence
of a diary, a collection of past transactions gleaned from bank statements can be
informative. If the investor is willing to disclose past transactions and decisions
to the adviser, these facts can paint a colorful and accurate investor risk profile.
The danger of this method is that individual investors can learn from past mis-
takes and thus their attitudes toward risk may have changed over time.

INVESTMENT HISTORY BY MARKET ENVIRONMENT

Finally, advisers can shed light on the risk profile of investors by putting their
investment history into the context of the markets. As discussed, the markets
in an investor’s formative years can leave a lasting imprint on the investor’s risk
profile. Investors who spent their formative years in the 1970s are likely to be

14
 Investor Risk Profiling

more averse to bond investments and more prone to seek inflation protection
than investors who spent their formative years in the 1990s. If an individual’s first
stock investments were made in the early 1980s or during the first decade of this
century, the individual’s attitude toward stocks might be very different from the
attitude of someone who made his first investments during the bull market of
the 1990s or in the last five years. Most investors today have never experienced a
period of steadily rising interest rates and the impact of such a regime on invest-
ments. In short, the financial history of an investor might show the adviser where
the investor might be overly sensitive to some risks or blind to some risks.

All of these tools—financial anamnesis, investment diaries, and investment

histories—should prove useful to advisers in their regular interactions with clients.

Ideally, the results of the discussions would be documented, and with the help
of these and other tools, the adviser can generate more reliable risk profiles in
the future. We are only at the beginning of the development of such tools; unfor-
tunately, the topic of how risk profiling can be improved in the future must wait
for a later time.

SUMMARY AND OUTLOOK

Risk profiling forms the foundation of financial advice to investors all around
the globe. Yet, the current practice of risk profiling via generic questionnaires
provides a weak foundation for risk profiles. The questionnaires used at the
moment are often not empirically validated and have little explanatory power.
Regulators are increasingly aware of this problem and are requiring better tools.
In its “Technical Advice to the Commission on MiFID II and MiFIR,” the European
Securities and Markets Authority states,

Investment firms shall take reasonable steps to ensure that the infor-
mation collected about their clients is reliable. This includes but is not
limited to . . . undertaking valid and reliable assessments of their cli-
ent’s knowledge and experience and risk they are willing to take . . .
and ensuring all tools employed in the suitability assessment process
are appropriately designed for use with their clients and are fit-for-
purpose. (ESMA 2014)

15
 Investor Risk Profiling

The crucial phrase in these sentences is “valid and reliable.” Current practice does
not conform to these standards.

These recommendations are not binding, but the report of ESMA was based on a
thorough vetting process with stakeholders from the financial industry.

Moreover, these recommendations can be expected to be enacted into law

within a few years. So, it is probably just a matter of time before advisers and
investment firms in the European Union will have to comply with these stan-
dards. From the viewpoint of the end investor, such high standards can only be
considered desirable, because they may reduce the risk of investments in unsuit-
able products.

Investment firms, for their part, could use these increased compliance demands
to their advantage. By designing “valid and reliable” tools, firms can increase the
trust their clients place in them and positively differentiate themselves from
their competitors. By being an early adopter, an investment firm can demon-
strate a clear understanding of why certain investment strategies or products
may or may not be right for a particular client. The firm can thus use such tools to
enhance the client’s experience with the firm.

In addition, most investors do not like to fill out generic questionnaires, but few
investors do not like to tell their story and talk about their past investment expe-
riences. So, why bother with questionnaires? Of course part of the answer is that
there will always be a need to document facts and data gathered from investors,
but with the ideas presented here, hopefully investment firms and advisers can
build a better foundation for their advice.

16
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19
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Briefs

INVESTOR RISK PROFILING:

AN OVERVIEW
• Suitability rules demand that practitioners assess the risk
profiles of investors before recommending specific investment
products or strategies.
• Current practice of using questionnaires to identify investor risk
profiles is inadequate and unreliable, typically explaining less
than 15% of the variation in risky assets between investors.
• Research has identified more reliable ways to assess investor
risk profiles, such as addressing the environment of an investor
as well as her lifetime experiences.
• Identifiable factors can be combined to build reliable risk
profiles—something that is increasingly demanded by regulators.

Joachim Klement, CFA

ISBN 978-1-934667-93-4
90000

CELEBRATING 50 YEARS OF RESEARCH

Available online at [Link] 9 781934 667934