In the space of just a couple of weeks in April, two organisations, both based in the UK and both offering risk-profiling tools for financial planners, emerged in the Australian market.
Why they are expanding into Australia now, and both at the same time, is still not entirely clear, beyond a dawning realisation that as the Australian financial planning market matures, driven principally by legislation, it’s becoming increasingly attractive for global service providers.
In a general sense, competition is good, and to that extent it will be good for local financial planners and their clients if the companies in question, Oxford Risk and Pocket Risk both offer viable alternatives to FinaMetrica – the most commonly used risk-profiling tool in Australia – and to more recent entrants, including Capital Preferences and others.
As FinaMetrica, co-founded by Paul Resnik, continues to expand its business in the UK (and elsewhere), so Oxford Risk and Pocket Risk are looking to expand in the opposite direction. Their timing puzzles Resnik, who says there’s so little growth and interest in risk-profiling among Australian financial planners that “I have no plans to allocate any more resources to the nothing that I am doing in Australia at the moment”.
Despite its origins in Australia, Resnik says FinaMetrica derives about half of its revenue from the UK, where risk-profiling is used extensively, about 20 per cent from the US and just 15 per cent from Australia, with the rest “dotted around the world”.
FinaMetrica has the advantage of incumbency – its risk-profiling tool was established back in 1998. Oxford Risk spun out of Oxford University in 2002, and Pocket Risk started operations in 2013.
At the very least, the arrival of the newcomers may prompt financial planners to look anew at the issue of risk tolerance, and the role it plays in ensuring investment solutions recommended to clients are both appropriate and suitable.
Pocket Risk founder and chief executive John Ndege says there’s clearly a growing compliance burden on financial advisers around the world, as governments legislate to raise standards and to protect consumers. He says this is the case in every country Pocket Risk operates in today – the UK, the US and Canada – and is starting to happen in Australia.
Ndege’s entry to the risk-profiling space is interesting. Formerly a Facebook analyst, he received shares in the company’s initial public offer (IPO). Suddenly having to think about investment, his thoughts turned to his risk profile. Ndege has come at the issue from a client’s perspective. He was living and working in the US at the time of the Facebook IPO and says he spoke to at least a couple of dozen financial planners about his situation. He found the majority said existing risk-profiling tools weren’t adequate.
“While I was having these conversations, people were saying they wanted a new interface, to change the questionnaire, to have additional features,” he recalls. “I built Pocket Risk in 2013.”
He says interest was initially greatest in the US, and the company spent most of its time marketing the tool there. It has since expanded into Canada and into the UK, Ndege’s home, and is now on its way to Australia. A small number of Australian financial planners have already found Pocket Risk online, and are successfully using it in their businesses. Ndege has customised the tool for Australia, creating a version using Australian-dollar currency denominations, and basing questions on localised real-life examples of market movements.
Any useful risk-tolerance tool must demonstrate both reliability and validity. Reliability means a test produces consistent results with a defined level of accuracy; validity means it tests what it says it’s going to test.
Risk has multiple dimensions and an up-to-date risk-profiling tool helps advisers address them holistically. For example, There’s risk tolerance, which is essentially a client’s psychological attitude towards risk (“How would you feel if you lost 25 per cent of your money?”). There is also risk capacity, or the client’s physical ability to take on investment risk (“How much can you afford to lose before you can no longer achieve your goals?”). Then there is risk necessity (“How much risk do you need to take with your money to achieve the goals you’ve set?”).
It’s the art, as much as the science, of financial planning that addresses each of these in a way that enables a client to achieve a given goal with the financial resources they have available, in a way that doesn’t keep them awake at night with worry, and which keeps them on track over time.
Where there are mismatches – say, a client’s current financial resources won’t get them to their goal without them taking on more risk that they can tolerate or afford – a-risk profiling approach sets the scene for a conversation between planner and client, and a potential change of plan. That could be moderation of the client’s goals (perhaps managing expectations down), or it could be further education on risk, what to expect from markets, and why.
In some cases, risk profiling will reveal that a client does not need to take on as much risk as they already are in order to achieve their goals.
One problem with all this is that almost all risk profiling is based on the same body of knowledge and theory, and most risk-profiling tools can trace their methodologies back to work by psychologist Michael J. Roszkowski in the mid- to late-1990s. There’s inevitably going to be some strong similarities between risk-profiling tools driven by the same psychometric testing engines. Which tool is right for which advice business will probably come down to individual advisers’ preferences, and to the support and other services the respective profiling businesses offer.
For and against
Risk profiling has its critics, as well as its supporters. Critics argue it’s just a convenient way for financial planners to channel clients’ money into model portfolios. They say the way people answer questions about risk, sitting at home in front of their PC or in their advisers’ office, can be different to how they think about risk in the heat of a major global financial catastrophe. They argue that a risk-tolerance questionnaire provides only a point-in-time snapshot. And while there’s evidence that an individual’s risk tolerance doesn’t change over the years – how they regard risk at age 20 is apparently not significantly different from how they regard it at age 60 – an individual’s risk capacity certainly changes over time. So can the client’s risk necessity, as asset values fluctuate.
Resnik says that while most credible risk-profiling tools are psychometric tests, “not all psychometric tests are created and maintained as equals”.
There are three critical issues for advisers, he says:
- Do the tests cover financial and investment risk tolerance, or just investment risk tolerance? He says most tests do only the latter, but financial advice covers many other matters beyond just investment. “Advisers will have a better understanding of their clients and how to work with them when they have a comparison between the ways their clients deal with financial matters,” he argues.
- To what degree are the tests and their results valid and reliable?
- What is the evidence for how risk scores are mapped to portfolios?
Assuming these questions can be answered of any putative risk-profiling tool entering Australia, again, choice in any market is generally a good thing, and the entry of two newcomers and the possibility of others to follow will at least draw attention to risk profiling, its uses and misuses, and its possibilities and limitations.
As Ndege says: “The main thing advisers are looking for is a better client experience.”