CFA Institute Research Foundation

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1 CFA Institute Research Foundation

2 CFA Institute Research Foundation Founded in 1965 Mission To provide independent, high-quality research that helps investment professionals effectively fulfill their duties with prudence, loyalty and care Types of content Monographs (books) Literature Reviews RF Briefs Occasional Papers Workshop for the Practitioner Webinars Audiobooks elearning and Learning Modules 2

3 New Content RF Briefs More concise content (5-15 pages) Global and regional topics Established and up-and-coming authors 3

EMEA RF Regional Research Council Barbara Petitt, CFA - Head, CFA Institute Journal Publications Bill Fung - RF Board Member Larry Siegel - RF Research Director Open - Society

4 EMEA RF Regional Research Council Barbara Petitt, CFA - Head, CFA Institute Journal Publications Bill Fung - RF Board Member Larry Siegel - RF Research Director Open - Society Representative UK Thorsten Hens - Society Representative - Europe Open - Society Representative Other Mathias Moersch, CFA - Academic Open - Regulator Representative Tom Joski, CFA Independent Advisor 4

5 Identifying Investor Risk Profiles: Ideas for Investors, Advisors and Regulators Joachim Klement, CFA, CFP Chief Investment Officer, Wellershoff & Partners Ltd.

6 What is a risk profile, anyway?

7 Risk profile = Risk capacity + Risk aversion Risk capacity Ability to take on financial risk based on economic circumstances (wealth, investment horizon, liquidity needs etc.) Risk aversion Psychological make- up of the investor and their emoeonal ability to take on financial risk Risk Profile Suitable investments 7

8 Regulatory Demands FIDLEG, Article 10: Ein Finanzdienstleister, der Finanzdienstleistungen erbringt, erkundigt sich über die finanziellen Verhältnisse und Anlageziele seiner Kundinnen und Kunden sowie auf deren Kenntnisse und Erfahrungen in Bezug auf die angebotenen Finanzinstrumente oderr dienstleistungen. MiFID II, Article 25(2): 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 including his ability to bear losses, and his investment objectives including his risk tolerance 8

9 How do advisors measure risk profiles?

10 Standard Process Define goals Fill out risk profile queseonnaire Regulators provide likle guidance how risk profiling can be done reliably. Score queseonnaire Scoring is done mostly in an ad hoc fashion without proper empirical validaeon. Determine asset allocaeon OMenEmes the link between queseonnaire scores and asset allocaeon is informal and without proper validaeon. Implement 10

11 Standard Process Standard Result FINRA Ombudsperson Report 2014: complaints about unsuitable investment recommendations (down from in 2009) Annual Report of UK Financial Ombudsman 2012/2013: 62% of complaints about investments and pensions was about sales and advice given. Beschwerdestelle des Deutschen Bankenverbands 2013: 87% of complaints in the area of securities and investments was about sales and advice. In the majority of cases investors claim, the bank did sell unsuitable products or did not disclose investment risks properly. 11

12 Risk Profile Questionnaires Based on a survey of 131 questionnaires Number of questions ranges from 1(!) to % of the questionnaires had at least one question on different investment scenarios. 65% of questionnaires had at least one question on time horizon. 33% of questionnaires asked about investor goals. 31% of questionnaires asked about investment experiences. 11% of questionnaires asked investors to define their risk profile directly. Source: Rice (2005) 12

13 Let me State This Again Based on a survey of 131 questionnaires 30% of the questionnaires did NOT evaluate investor behavior under different scenarios. 35% of questionnaires did NOT ask about the investor s time horizon. 67% of questionnaires did NOT ask about investor goals. 69% of questionnaires did NOT evaluate investment experiences. Very few questionnaires asked about withdrawal rates and liquidity needs. None of the questionnaires used visualization with with regard to the investor s own financial situation or elicited feelings and emotions that would occur in times of market stress. Source: Rice (2005) 13

14 Does it work?

15 Explaining Investor Portfolios An analysis of Canadian investor portfolios Variation of risky share in portfolio explained by variables (adj. R2): % 3.6% Age Variation explained if influence of advisors is taken into account (adj. R 2 ): 31.6% Gender Risk tolerance Time horizon Financial knowledge Income Net worth Occupation Source: Foerster et al. (2014) 15

16 Changing Risk Aversion A study of real client behavior of Barclay s Wealth during 2008 and 2009 Source: Weber et al. (2012) 16

17 Questionnaires Are Unreliable Socio-economic variables like age, gender, income, time horizon or risk aversion elicited through questionnaires typically only explain 5% to 15% of the variation of investor portfolios. On top of that there exists evidence, that risk aversion may at least be partially variable over time and dependent on the environment in which financial decisions are made. 17

18 So, what works then?

19 Genetic Component of Risk Preferences A Study of Swedish Twins Source: Barnea et al.(2010) 19

20 Traumatic Memories of the Great Depression Depression babies! Source: Malmendier and Nagel (2009) 20

21 Memories of High Inflation Memories of 1970s high inflation influenced for about 10 to 15 years Source: Ehrmann and Tzamourani (2009) 21

22 The Importance of the Formative Years Recessions during our formative years influence our political beliefs Source: Giuliano and Spilimbergo (2009) 22

23 What could advisors do?

24 An Experiment You are Professor at your local university. Part of your job is to make sure student report cards have been processed correctly. The following rule has to be obeyed: If a person has a rating D, then his documents must be marked code 3. One side of a student s report card identifies the student s rating, the flip side contains the student s number code. Source: Wason (1966), Cosmides (1989) 24

25 An Experiment Indicate only those card(s) you definitely need to turn over to see if the documents of any of these people violate this rule. D F Source: Wason (1966), Cosmides (1989) 25

26 An Experiment You are a bouncer in a bar in Frankfurt. Part of your job is to make sure no underage person drinks alcohol. The following rule has to be obeyed: If a person is drinking beer, then he must be over 16 years old. The following cards have information about four people sitting at a table in your bar. One side of the card tells what a person is drinking and the other side of the card tells that person s age. Source: Wason (1966), Cosmides (1989) 26

27 An Experiment Indicate only those card(s) you definitely need to turn over to see if any of these people are breaking this rule. Drinking beer Drinking coke 18 years old 15 years old Source: Wason (1966), Cosmides (1989) 27

28 An Experiment Percentage of people turning cards 1 and 4 Source: Wason (1966), Cosmides (1989) 28

29 Be Meaningful If you have to use a questionnaire make sure the questions are meaningful I recruited 489 people through Amazon s Mechanical Turk website. The recruits were asked to answer one of three simple risk profiling questionnaires: Version 1 (Percentage frame): Assume you invest 100% of your savings in a stock. After one month the investment has declined by 10%. What do you do? Version 2 (Dollar frame): Assume you invest 100 dollars of your savings in a stock. After one month the investment has declined by 10 dollars. What do you do? Version 3 (Million Dollar frame): Assume you invest 10 million dollars of your savings in a stock. After one month the investment has declined by 1 million dollars. What do you do? Recruits could choose between Buy more, Do nothing, and Sell. Scenarios were created for 10% gain, 10% loss, 30% loss and 50% loss. 29

30 Be Meaningful If losses become substantial in dollar terms, more investors would sell Source: Wellershoff & Partners 30

will be between X 2 and Y 2 2. Distribution: Show the distribution of returns 2.

31 Be Graphic(al) Four different ways to show the impact of risk 1. Description: In 70 out of 100 cases your return will be between X 1 and Y 1, in 95 out of 100 cases your return will be between X 2 and Y 2 2. Distribution: Show the distribution of returns 2. Experience: Participants have to draw possible returns from the distribution. Only the final return is given. 4. Risk tool: Build the distribution out of single draws Source: Kaufmann et al. (2013) 31

32 Be Graphic(al) Risk tool leads to lower overoptimism and higher allocation to risky assets Source: Kaufmann et al. (2013) 32

33 Perform a Financial Anamnesis We cannot ask our clients to pass genetic testing in order to identify their genetic disposition to take risks. Similar to a doctor who asks for the medical history of your parents and siblings to assess your risks of contracting cancer, we can do a financial anamnesis of our clients. A prevalence of financial risk-taking in an investors family can be an indication of a genetic prevalence for risk-taking: Children of entrepreneurs are significantly more likely to become entrepreneurs themselves. A prevalence for trading and gambling in family members can indicate a higher propensity to take on risks. 33

34 Start Investment Diaries Investors should have an investment diary, where they note every investment decision taken and the reasons for the decision. Over time this diary can become the best tool to assess individual strengths and weaknesses in financial decision making. If an investor has no investment diary the advisor can ask for a summary of previous investment decisions (e.g. account statements) to perform a forensic analysis 34

35 Discovering Experience-based Risk Preferences An example of a retiree in Switzerland Source: Wellershoff & Partners 35

36 And what about regulators?

37 Increasing Regulatory Demands ESMA recommendations on Article 35 of MiFID Implementing Directive (19 December 2014): (viii) Investment firms should take reasonable steps to ensure that the information collected about their clients is reliable. This includes, but is not limited to: b. Undertaking valid and reliable assessments of their client s knowledge and experience and risk they are willing and able to take, including their ability to bear the investment risk; c. Ensuring all tools employed in the suitability assessment process are appropriately designed for use with their clients and are fit-for-purpose, This includes, for example, any risk assessment profiling tools that may be used or tools to assess a client s knowledge and experience. 37

38 Conclusions Regulators demand that investment firms assess the risk profile of investors. Only suitable products can be offered to investors. Currently, investor risk profiles are assessed through questionnaires: Questionnaires are typically badly constructed and lack explanatory power. In practice this leads to misselling and loss of trust in the financial industry. Instead advisors would do better if they relied on an analysis of real life investment decisions as well as meaningful scenarios for hypothetical scenarios. Regulators should and could improve current practice: Regulators could demand proof that risk profiling tools are reliable. Regulators could proactively design risk profiling tools as model tools for investment firms. 38

39 Kontakt Wellershoff & Partners Ltd. Zürichbergstrasse Zürich T // F info@wellershoff.ch //

RISK PROFILING AND TOLERANCE: INSIGHTS FOR THE PRIVATE WEALTH MANAGER

Research Foundation Briefs RISK PROFILING AND TOLERANCE: INSIGHTS FOR THE PRIVATE WEALTH MANAGER Edited by Joachim Klement, CFA RISK PROFILING AND TOLERANCE: INSIGHTS FOR THE PRIVATE WEALTH MANAGER Edited