Citywire printed articles sponsored by:
View the rest of this gallery online at http://citywire.co.uk/new-model-adviser/gallery/a698605
Graham Bentley: the problem with attitude-to-risk tools
by Graham Bentley on Aug 20, 2013 at 14:14
Attitude-to-risk questionnaires are neither effective nor accurate and advisers should use a method that takes into account clients’ subjective expectations, writes Graham Bentley of gbi2.
The regulator expects advisers to conduct a meaningful risk assessment process. This is often fulfilled by an attitude-to-risk (ATR) questionnaire.
However, ATR questionnaires are neither an effective nor an accurate tool for understanding the client’s attitude to loss, reflecting more the interests of providers.
Focus on the desired outcome
ATR questionnaires are a tool of convenience for advisers: the higher the score, the higher the respondent’s apparent propensity to take risks. Many providers now pin an expensively purchased risk badge to their funds and portfolios, in the expectation that an army of ‘risk level five’ investors will be shoehorned into them.
However, while attitude to risk is general, the required investment outcome is specific. A propensity to drive fast does not mean you always need to, or should, given the road conditions.
The fact that you are a ‘risk level 10’ is irrelevant if your investment is liability driven, requiring only a 4% yield to achieve your objective. ATR answers often reflect the ego of ill-informed respondents.
I may say I can stand a loss of 10% if I am led to believe it is an unlikely scenario. My attitude to risk does not necessarily reflect my capacity for accepting it: a fool and his money are soon parted.
Difference between risk and uncertainty
More fundamentally, there is a difference between risk and uncertainty. Risk implies probability: what is the chance in a coin-tossing game I might toss three consecutive heads? Should I accept a reward of £5 for a £1 bet if I did toss three heads?
I can calculate the odds, and make an informed decision, but investment is not like that. There are some things we believe to be true: that bond prices are less volatile than equity prices, for example.
However, unlike the laws of physics, or mathematical probability, these behaviours are not predictable and repeatable.
An in-depth risk discussion, with uncomplicated collateral the client can refer to, can be more useful than an ATR questionnaire. The asset allocation process also needs to be less prescriptive, free of volatility definitions, but starkly commensurate with the capacity for loss. Loosely speaking: how ‘losable’ the client’s capital is, and how ‘usable’ the anticipated portfolio’s outcome is, underpins adviser expertise more than a set of tick boxes.
There is a technique that combines a mathematical approach with a client’s involvement, but in a more meaningful and conversational manner. The process uses what psychologists term ‘subjective probabilities’.
The client wants to invest some money. They do not want to lose it. Consequently, they do not want ‘a lot’ of ‘big’ price falls. Test the client to see what ‘a lot’ means to them. Every month? Six months? Five years? Then you need to test what ‘big’ means. A fall of 5%? £10,000? It will vary from person to person.
There is a saying in the military: ‘Expect the best, plan for the worst.’ Once your client is primed to plan for the worst, then you can ask: what has history told us?
Show clients what ‘a lot’ looks like in practice, and how big the falls have been. Helpfully, fund groups can provide this information.
You then need to present possible negative scenarios, for example: ‘What if you could not pay the school fees? How would you feel?’
Once the client has some perspective, you can retest them on what they understand to be ‘big’ and ‘a lot’ in relation to gains and losses.
Maximum acceptable loss
Using a more meaningful method than an ATR questionnaire means the client’s subjective expectations influence the asset allocation in a relatively straightforward manner.
You ask the client what their maximum acceptable loss is in a single year. For instance, assume their maximum acceptable loss is 20% (call it 0.2).
You then add the risk-free return, for example, the yield on a five-year treasury, or savings bond. Assume the current yield on a five-year gilt is 1.25%, which gives us 0.2125.
Now ask the client what the maximum loss is they think could happen in a single year, planning for the worst. Say he thinks that’s 30%. Add the risk-free rate and that gives us 0.3125.
By dividing the first calculation by the second, you get the maximum exposure to non-cash assets, 0.2125 divided by 0.3125, which is 0.68 or 68%.
If you used a building society five-year bond rate of 2.5%, the result would have been 69%. The portfolio behaviour now matches client’s assumptions rather than the provider’s.
Completing a questionnaire is not mandatory, but attitude to risk, and capacity to accept it, does need to be established and audit trailed.
A relevant high-level asset allocation can match client expectations without using questionable assumptions and woolly portfolio theory.
Graham Bentley is managing director of gbi2.