Presentation given by Paul Resnik (Co-Founder, FinaMetrica) at the National Institute of Securities Markets (NISM) in Mumbai, India. It emphasizes on the importance of measuring risk tolerance of investors in the process of matching investment products to an individual's needs. Visit www.riskprofiling.com to know more.

2. The Imperatives of
Investment Suitability
 National Institute of Securities Markets (NISM)
 March 13, 2013
 paul.resnik@finametrica.com
 www.riskprofiling.com
2

3. Tipping Point to New Order
Investment-centric Investor-centric
Product First
Investor First
Investment first Plan first
Investment differentiated Investments commoditised
Idiosyncratic portfolios Model/controlled portfolios
Investment advising Client advising
Product remuneration Service remuneration
Caveat Emptor Fiduciary obligations
Adviser „s idiosyncrasies Process-driven advice
Paternalistic advice Collaborative decision-
“I know this fund is right making
for you” Client‟s informed consent

4. What We‟ll Cover Today
 Risk Profiling Stages  How to develop a
meaningful
 The “five proofs” investment suitability
suitability process...ADAPT
 Linking risk scores to  Using the past to
a prospective asset frame investment
allocation expectations

5. Risk Profile
How much risk
you need to take.
Risk
Required (Financial)
How much risk you How much risk
can afford to take.
Risk you prefer to take.
(Financial) Profile (Psychological)
Risk Risk
Capacity Tolerance

6. New Indian Regulation
 Commences April 2013
 Consistent with UK Regulation
 „Optional‟ for most in supply chain?
 Requires understanding of client needs

7. Background to New Regulation
 Inspired by 2008 banking debacle
 FSA in UK set the tone
• Huge penalties for misselling-£10 billion +
• Found flaws in 9/11 tests
• Role model- practice of UK elite planners
 Based on European Regulation
 Similar in Singapore, HK and NZ


8. Risk Profiling Stages
Stage 1 • Portfolio Picker questionnaire used to
Early-mid 80s deliver investment recommendation.
Stage 2 • Portfolio Picker recommendation projected
Late 80s-Early 90s against goal(s).
Stage 3 • Scientific risk tolerance assessment
Mid-late 90s introduced. Couples assessed separately.
Stage 4 • Risk capacity introduced. Risk profiling
Early-mid 00s now complete.

9. „Portfolio Picker‟ Questionnaires
 8 -10 questions: goals, time horizon, investment
experience, return expectations, risk capacity,
risk tolerance etc.
 „Bad‟ questions are common.
 Trade-off decisions are made opaquely on a
third party‟s values.
 Clients have a sterile, empathy-free experience.

10. 131 „Portfolio Pickers‟
% Stocks Recommended
100%
100%
80%
60% 70% 50%
40%
20%
0%
0%
0.5 1 1.5 2 2.5
Least Most
Risky Risky
Answers Answers
Douglas Rice PhD, Golden Gate University

11. Advisors‟ Assessments
 Are less accurate than clients‟ self-estimates
 Exhibit gender bias
 Overweight other demographics
 Correlate with test scores at ~.4
Advisors would be more accurate if they made
no attempt to assess clients‟ risk tolerance and
simply assumed everyone was average!!!

12. Advisory Businesses Put Their
Reputation & Corporate Value at Risk
 Allow their recommended fund managers to misleadingly explain risk,
 Inaccurately and inconsistently assess investors‟ risk tolerance,
 Do not have a defensible and rigorous method for their advisers to
arrive at portfolio recommendations,
 Accept their advisers‟ use of non-standardised and personal
descriptions of financial risk and volatility with investors.
 What is said to clients is often different from what is written to them.
Fundamental problems created by inconsistent risk
communication lead to widespread investor confusion.

13. A Robust & Integrated Approach to
Communication Consistency
 Make sure you know what your test tests.
Psychometric testing is your best defence!
 Evidence based links from risk scores to
Asset Allocations/Portfolios
 Common language of risk used by all
 Standardised descriptions of risk

14. FinaMetrica
 Psychometric personal financial  Established in 1998
risk tolerance assessment and
 75% subscribers are international,
application methodologies for
translated into 7 languages
individual investors
 Subscription renewal rate 89%
 Privately owned, Australian
business commenced 1998  520,000+ profiles completed,
 Co-founders combined  Up to 12,000 new profiles per
experience 80 years in all parts month
of service chain
 „Practice Solution‟ for small to large
 5,300 leading edge advisers in advisory groups
21 countries, directing £20 billion
 Tailored „Enterprise Solution‟ for
plus
multi-channel businesses
 .

15. Risk Tolerance: Normal Distribution
Risk Group 1 2 3 4 5 6 7
Score Range 0-24 25-34 35-44 45-54 55-64 65-74 75-100
No. in Group 1% 6% 24% 38% 24% 6% 1%

16. Typical Investor Responses
Risk Group 10 year Returns Downside Comfort
1.5 to 2 tim es , m ore For s om e 10% but for
3
likely 2. others 20%.
2 to 2.5 tim es , m ore For m os t 20% but for
4
likely 2. s om e 33%.
2.5 to 3 tim es , m ore For s om e 20% but for
5
likely 2.5. m os t 33%.
BDs 10 year Annualised Nominal Returns
Historical Recent
Best 10.9% 10.5%
Good 10.8% 10.3%
Average 9.1% 8.4%
Poor 7.1% 7.1%
Worst 7.1% 7.1%

17. Typical Investor Experiences
Compared with 1.5 x BDs Compared with 2 x BDs Compared with 2.5 x BDs
Actual vs. Expectations Actual vs. Expectations Actual vs. Expectations
Fell short Met Exceeded Fell short Met Exceeded Fell short Met Exceeded
0% 0%
24%
40% 40%
60%
36%
100%

18. Proof that Risk Tolerance is Stable-
Monthly Average Risk Tolerance Scores
January 2007 to June 2009
AUS UK US
100
80
60
40
20
0
Jan 07 Jul 07 Jan 08 Jul 08 Jan 09

19. Risk tolerance tends not to
change, what changes is
investor‟s perception of risk.
 We tested and surveyed the same investors before and after
the market falls in 2008
 Before the fall investors believed there was little risk of losing
money
 After the market corrected investors believed there was a
higher risk of losing money
 Conclusion is that investors are generally poorly informed
about the riskiness of their investments.

20. Risk Tolerance is Stable
 One of the few parts of an investor‟s life that tends
not to alter year on year.
 Assets, liabilities, income, expenses, expectations
and preferences, for instance, all change.
 Basis for regular discussion between adviser and
investor to establish investor‟s expectation of risk
and return in their portfolio.
 Basis for ongoing fee based relationship.

21. The Five Proofs
A simple, self-administered suitability test
1 • Prove you know your client: their situation, needs and
aspirations.
2 • Prove you identified mismatches and looked at alternative
strategies.
3
• Prove you know the product(s) recommended.
4 • Prove you explained the risks in the plan and the product(s)
recommended.
5 • Prove you received your client‟s properly informed consent to
the risk in the plan and the product(s).

22. The „ADAPT‟ Suitability Process
• Awareness of their risk tolerance enables the investor to
better understand themselves compared to other investors
[including differences reported].
• Discuss the report with client[s] particularly differences
from the risk group and any partner. Agree risk score.
• Asset allocation link from agreed risk score
• Project asset allocation forward using cash flow modeller
to confirm moneys will be available to meet clients goals
as they fall due and test for risk capacity
• Test client understands the investment, particularly frame
performance and volatility expectations using the Indian
Risk and Return Guide at www.riskprofiling.com/

23. Gap analysis is the “gap”
between …
 risk required (the risk inherent in the return required
to achieve goals), and
 risk tolerance (the preferred risk/return trade-off)

24. Linking Spreadsheet*
Risk Tolerance Risk Required
* Methodology for comparing portfolio risk to risk tolerance

25. Correlation of Risk Scores
and Growth Asset Exposures
% Growth Assets by Risk Tolerance Score (n=53,723)
y = -2.5508E-6x3 + 3.8656E-4x2 - 3.0138E-3x - 1.3442E-2
R² = 9.9887E-1
100%
90%
80%
% Growth Assets
70%
60%
50%
40%
30%
20%
10%
0%
0 10 20 30 40 50 60 70 80 90 100
Risk Tolerance Score

26. Comfort Zones
% Growth Assets
Plus/Minus >20% Plus/Minus 11-20% OK Risk
100%
90%
80%
Discomfort
70% Too Much Risk
60%
50%
40%
30% Discomfort
Too Little Risk
20%
10%
0%
0 10 20 30 40 50 60 70 80 90 100
Risk Tolerance Score

27. Risk
Tolerance
Too Little Risk Too Much Risk
Low High
Risk Risk

28. Comfort Zones
Risk Tolerance to % Growth Assets
Enter the risk tolerance score to see the Comfort/Discomfort ranges for the % of
Growth Assets in a portfolio.
Enter Risk Tolerance Score 50 % Growth Assets Ranges
Too Little Risk: < 23%
Marginal: 23% - 32%
OK Risk: 33% - 52%
Marginal: 53% - 62%
Too Much Risk: > 62%
% Growth Assets to Risk Tolerance
Enter the % of Growth Assets in the portfolio to see the Comfort/Discomfort risk
tolerance score ranges for that portfolio.
Enter % Growth Assets 60% Risk Tolerance Score Ranges
Too Much Risk: < 49
Marginal: 49 - 54
OK Risk: 55 - 66
Marginal: 67 - 73
Too Little Risk: > 73

29. Gap Analysis
Enter Name Jean Enter Risk Tolerance Score* 50
Enter Current Portfolio 50% Growth Assets
Enter Target Portfolio 70% Growth Assets
Current Portfolio Target Portfolio
Jean 50
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
% Growth Assets

30. Gap Analysis
Enter Name Jean Enter Risk Tolerance Score* 50
Enter Spouse's Name Bill Enter Risk Tolerance Score* 60
Enter Current Portfolio 60% Growth Assets
Enter Target Portfolio 70% Growth Assets
Current Portfolio Target Portfolio
Jean 50
Bill 60
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
% Growth Assets

31. Example of Portfolios Linked to
FinaMetrica Risk Scores
Risk Tolerance Score Ranges
Best Fit Too Marginal OK Risk Marginal Too
Asset Allocation Growth Assets Much Little
1 Cash 0% 0 - 25 Risk
n.a. n.a. 0 - 23 24 - 31 Risk
> 31
2 Conservative 30% 26 - 44 < 24 24 - 31 32 - 44 45 - 50 > 50
3 Mod'tely Conservative 50% 45 - 57 < 38 38 - 44 45 - 56 57 - 62 > 62
4 Balanced 70% 58 - 71 < 51 51 - 56 57 - 69 70 - 78 > 78
5 Growth 90% 72 - 86 < 63 63 - 69 70 - 94 n.a. n.a.

32. Comparing Historical Performance
 Link client‟s risk tolerance score to portfolio outcomes
 Valuable when clients are couples with different risk
tolerances & investment may be an „issue‟
 Easily frames client‟s investment expectations
 Lowers their hope of expected returns to realistic levels
 Prepares them for the inevitable investment volatility
 Shows you are honest and trustworthy, you are not
hiding the truth!

33. Investment Experience
R1,000 Invested for Five Years
Monthly Real Values
R 1992 1997 2002 2007
2,500
2,000
1,500
1,000
500
-
- 10 20 30 40 50 60
Months

34. Comparison of Last 25 Years Client
Portfolio Experiences: 1 Year Returns
Nominal Real Return Nominal Real Return
Return on on R1,000 Return on on R1,000
Returns 100% 50%
Growth Growth
Assets Assets
Best 244.4% R2,825 112.5% R1,743
Average 24.1% R1,147 16.7% R1,081
Worst -53.4% R421 -25.6% R715
You can find the data for 11 Indian portfolios with growth asset exposure from
0% to 100% at www.riskprofiling.com/Risk_and_Return_IND_2.0.pdf

35. Comparison of Last 25 Years Client Portfolio
Experiences: 10 Year Annualised Returns
Nominal Real Return on Nominal Real Return
Annualised R1,000 Annualised on R1,000
Returns Return on Invested in Return on Invested in
100% Growth 100% Growth 50% Growth 50% Growth
Assets Assets Assets Assets
Best 28.8% R4,787 21.1% R2,942
Average 14.9% R2,203 14.0% R1,908
Worst 2.4% R634 7.8% R1,057
You can compare Indian portfolio performance with similar data from UK, US,
Australia and several other countries at www.riskprofiling.com/systemresources
Look at our country specific Risk and Return Guides and Charts

36. 3 Largest Falls Over Last 25 Years for 100%
and 50% Growth Asset Exposed Portfolios
100% Start Depth of Months Months to 50% Start Depth of Months Months
Growth Fall Fall in Fall Recover Growth Fall Fall in Fall to
Assets Assets Recover
1 Dec- -57.3% 14 21 1 Mar- -26.9% 13 8
07 92
2 Feb- -52.9% 19 37 2 Dec- -23.0% 11 5
00 07
3 Mar- -45.9% 13 8 3 Feb- -22.2% 19 20
92 00
Investors experienced half the „Black Swan‟ volatility, saw their funds recover
more rapidly with only marginally lower returns 14.9% pa v 14.0% pa

37. Monthly Quarterly
Half-Yearly Yearly

38. Link of Risk Scores to Portfolios
and Indian Risk and Return Guides
Risk Tolerance Score Ranges
Best Fit Too Much Marginal OK Risk Marginal Too Little
Asset Allocation Growth Assets Risk Risk
1 Very Conservative (1) 0% 0 - 18 n.a. n.a. 0 - 23 24 - 31 > 31
2 Very Conservative (2) 10% 19 - 28 n.a. 0 - 11 12 - 31 32 - 37 > 37
3 Conservative (1) 20% 29 - 35 < 12 12 - 23 24 - 37 38 - 44 > 44
4 Conservative (2) 30% 36 - 41 < 24 24 - 31 32 - 44 45 - 50 > 50
5 Balanced (1) 40% 42 - 48 < 32 32 - 37 38 - 50 51 - 56 > 56
6 Balanced (2) 50% 49 - 54 < 38 38 - 44 45 - 56 57 - 62 > 62
7 Balanced (3) 60% 55 - 60 < 45 45 - 50 51 - 62 63 - 69 > 69
8 Growth (1) 70% 61 - 66 < 51 51 - 56 57 - 69 70 - 78 > 78
9 Growth (2) 80% 67 - 74 < 57 57 - 62 63 - 78 79 - 92 n.a.
10 High Growth (1) 90% 75 - 86 < 63 63 - 69 70 - 94 n.a. n.a.
11 High Growth (2) 100% 87 - 100 < 71 71 - 78 79 - 100 n.a. n.a.

39. The Way Forward for Investment Advisors
 Prepare for more regulation, it‟s inevitable
 Take control of investor‟s investment expectations
 De-emphasise alpha chasing and promote wealth protection
 Standardise portfolios
 Encourage clients to take the investment decisions ie move to
„informed consent‟ model
 Need to emphasise non-investment related benefits of
financial advise in proposition to clients.
© FinaMetrica Pty Limited 2011 39

40. Thank You
paul.resnik@finametrica.com
www.riskprofiling.com
© FinaMetrica Pty Limited 2011 40