Adviser Insight: Why we need a new approach to risk

An objective calibration of financial risks could do a lot to help advisers discuss this issue with clients clearly, free from subjective preconceptions that so often cloud the picture, says Steve Buttercase of Sense Financial.

I bet you don’t remember the risk assessment that was carried out before you bought your first house; it may be some time ago. Or perhaps you are too young to have stepped on to the fictitious housing ladder with its unwritten guarantee that the only way is up; ladders don’t typically go down in metaphors although many do so in life.

Those struggling for total recall should stop now because there wasn’t an assessment – the biggest investment of your life contains no warning at all.

I am sure you received plenty of paperwork regarding risk for the loan you took out or for any peripheral financial products, whether actually required or not, and you may even have read some of it. However, when it comes to the inherent risk of actually buying a house, there is not a warning in sight.

Units of danger

I was recently at my daughter’s school prize-giving, where the guest speaker was Professor Spiegelhalter, a Cambridge luminary on the subject of risk or, as he prefers to call it, ‘uncertainty’. After capturing the audience immediately with the statement that statistically Ecstasy is less dangerous for children than horse-riding (a fair few mutters – this was Cambridge remember), he began to introduce us to the concept of the micromort.

A micromort is a unit of deadly risk, where there is a one-in-a-million chance of death being the outcome. For example, 230 miles in a car represents one micromort and so does 6,000 miles on a train, three flights on an aircraft or six miles on a motorcycle. You get the idea. Other interesting activities that increase the death risk by a single micromort include smoking 1.4 cigarettes, spending an hour in a coal mine, eating 1,000 bananas and spending a weekend in New York.

Prof Spiegelhalter extrapolated this idea of a unit of risk to then introduce the idea of the microlife: that is a 30-minute reduction of your life expectancy as a result of a certain activity, condition or situation. So now two cigarettes can cost you one microlife, a chest X-ray three, a full CT scan 180 and so on. This allows students of risk to make a sensible comparison between different, seemingly unrelated, activities using an agreed scale or point of reference. In this way they can assess the danger more scientifically without being steered off course by emotions or intuition.

An adviser’s guidance on risk

Financial planners are forced to understand and communicate risk in an entirely different way.

Many have stuck with the basics of educating clients and motivating them within a framework of a tailored financial plan. This approach has worked well for decades and, to be fair to the Financial Services Authority, its guidance consultation ‘Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection’, published in January this year, did acknowledge good practice and said its findings were largely based on higher risk firms.

Yet many IFAs have failed to get to know their client personally and in depth and have instead hidden behind software programs, stratified sampling, absolute return alchemy, best advice manuals and (worst of all) risk assessment profile questionnaires.