Unless you have been living under a rock for the past few months, you are probably aware the regulator is becoming increasingly concerned about the various risk profiling tools that are available to advisers.
I share this concern. However, that is not to say I have up my sleeve, or have come across, a perfect solution. I do not believe one exists.
Risk means different things to different people.
If I were offered the opportunity to do a bungee jump, I would politely decline, while others would literally ‘jump’ at the chance. My response would essentially boil down to fear. In other words, a reaction to the perception of risk.
Fear is formed through referential experiences; reference points that you collect throughout life that help you to make sense of reality and affect how you interpret it. We also use other people’s reference points. For example, I have never shot myself, but I know it is not a good idea because I have seen reference points played out in films and books (I have also used knowledge and logic).
Perception versus reality
A client’s investment knowledge and reference points come into the equation of perceived risk.
If your client has experience of investment markets, they will understand that markets rise and fall. They may have personally experienced both the ups and downs. However, if the client’s reference points are gathered from the media or other external influences, their perception of the risk may be based on bias, third-hand knowledge or inaccurate information.
You do not have to go back too far to find examples of the media framing our beliefs. The perfect example is the headlines both before and in the immediate aftermath of Britain’s vote to leave the EU:
The Telegraph: 15 June 2016: ‘FTSE 100 loses £100bn in four days as Brexit paralyses markets and pound crumbles.’
The Guardian, 24 June 2016: ‘FTSE 100 and sterling plummet on Brexit vote.’
But what really happened in June 2016? The market ended up going up by 5.4% over the month.
Capacity for loss
How can this help us when risk profiling our clients?
The feeling of fear can only really exist when thinking about the future. Right here and now a would-be investor’s cash is safe. It is the fear of loss that creates the reluctance to take risk and in some cases the perception may be spot on.
This is where a client’s capacity for loss comes into play. A client’s capacity for loss is different to their attitude to risk. The attitude to risk examines how much risk they are willing to take, whereas their capacity for loss is the amount of risk they are able or can afford to take.
This is where decisions need to be made with the brain, not the heart.
I have seen risk profile questionnaires that seek to determine a client’s capacity for loss and this, to my mind, is completely wrong.
A client’s capacity for loss should be determined by the adviser’s own responsible assessment of the client’s financial standing.
Making an assessment
If a client has £100,000 to invest and needs to generate £10,000 for the next 10 years with no other assets or income, ignoring the effect of inflation, that client’s capacity for loss is zero, zilch, nothing.
That client cannot afford to lose one penny of that money and so should not be investing in any assets except cash and National Savings & Investments products.
If the same client has a final salary scheme that will cover the £10,000 for the next 10 years and beyond, the capacity for loss becomes almost infinite, although I would have to factor in some consideration for care fees within this assessment.
What this simple example demonstrates is that no one tool can perfectly measure how much risk a client is willing to take, is able to take or what relevant, unbiased reference points they are using to make their decision.
The only way to ensure the client is using objective and logical analysis is to ask, advise and support them as their independent adviser.
What advisers miss
What I often see missing is a measure of how much risk a client needs to take, and this comes back to my gripe about fact-finding.
Not knowing a client’s objective is like taking a road trip with no destination. While we might know whether the client wants to take a cautious, balanced or adventurous route, how do you or the client know if they have arrived?
An adviser’s job is to identify a client’s goals and help them achieve them in the most risk-averse way possible.
A client might have a cavalier attitude to risk and an unlimited capacity for loss, but if it is not needed to achieve their goal, it would be irresponsible to expose them to unnecessary risk.
The opposite is also true. Consider a client aged 40 with a cautious attitude to investment risk and very little or no capacity for loss, and you are advising them with regards to their pension assets.
If the target is unachievable using a cautious portfolio, the risk should be scaled up to reach the target. The client cannot access those assets for another 15 years, so the capacity for loss is almost irrelevant. Providing you are not putting the pension on black in a casino, the client has the timeframe to absorb any investment volatility.
Caveats obviously apply. So in this case, offering reassurance to address their exaggerated perception of the risk, would be the right approach.
This is why documenting the client’s investment or goal timeframe is also of utmost importance.
Risk profiling tools have their place. Like all tools, they should be used for assistance, but only by operating the tools with knowledge and responsibility will you ensure they are effective.
The tools are a line in the sand, a conversation prompt, which, together with your own assessment of the client’s capacity for loss and investment timeframe, should inform a suitable split of growth and defensive assets that will enable the client to achieve their goals.