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Behavioural risk assessment - don’t fall foul of the cautiously greedy
investor!
by Derek Stuart, Director, The Silent Partner & Mik Cons, Managing
Director, 1st Software
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| Derek Stuart,
Director, The Silent Partner |
Operating in an increasingly
regulatory climate has already caused many burdens for adviser
firms, not least with the increased costs associated with this.
Mitigating the risks within an adviser business can help reduce the
worries of regulation but ultimately the solution must lie with
reducing the risks associated with actually providing advice.
Just weeks ago we put this theory to
the test when we researched the opinions of advisers on their
attitudes to risk and the result was an outstanding one: 73% claimed
they were very concerned about their client’s understanding of risk
and a further 24% said they were
somewhat concerned. This left only 3%
of the adviser community
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| Mik Cons,
Managing Director, 1st Software |
which actually felt they had no
concerns about assessing and taking all
the responsibility for their clients’
understanding of risk.
For the past 15 - 20 years financial
advisers have used the scale of 1 - 10 to assess what clients are
prepared to accept in terms of risk. But what does the scale indicate?
It provides a false comfort which, in the wrong market conditions will
leave both parties unsatisfied.
On a very simple basis, the current
practice of assessing risk on a scale of 1 – 10 takes no account of
time. A balanced Managed fund may be regarded as a 5, but what if the
client was only investing for three years and in addition was taking a
5% pa income? Talking about expected returns with clients can be a
minefield as they usually want as much as they can get for little or
no risk. The bear markets may have brought a touch of realism but does
your client fully understand inflation and real rates of return? Many
clients do not understand the concept and the longer they are
investing, the more of an issue this becomes as we have a
responsibility to assist them in achieving their financial goals.
Clients need to understand the trade
off between risk and reward, and IFAs need to document it. Some
clients will give you the answers they think you want in order to
proceed, say, with a drawdown plan, but how does the adviser know how
the client really feels behind the exterior? Good and experienced
advisers instinctively know their clients however, if you look at any
upheld complaints regarding advisers it mainly comes down to lack of
documented evidence of the rationale. You can't win with a cautiously
greedy client.
More sophisticated systems are required
to ensure a greater chance of the client being comfortable with the
risk v return trade off and the adviser being able to demonstrate the
process behind selection and be sure he understands how the client
feels about risk. This has led to a number of risk profilers entering
the market but like the scale of 1 – 10, many could provide false
hope. Like any car or OEIC, you need to check what is under the
bonnet.
There are different elements to these
tools and each risk profiler may contain one or all of them. The risk
and reward tolerance indicators adopt a scientific approach to the
conventional 1 to 10 analysis. They are based upon a series of
mathematical assumptions driven by the responses to certain key
questions in areas of "Risk", "Return" and "Time", all three being
critical to arriving at the type of model asset allocation that might
best fit the investor profile.
Stochastic modellers provide the
probability of reaching a certain target return. They achieve this by
running literally hundreds of thousands of statistics to arrive at the
predicted likelihood of hitting a given target. The investor is asked
a number of questions regarding their “required return” and the
software assesses different scenarios to arrive at high, medium and
low probability asset allocation models. The investor then selects
from the “range”.
It is the third aspect that gets under
the skin of the client and takes these modellers to the next level –
behavioural analysis. In making financial decisions, investors are
influenced by gut feelings and intuitions. The “logical” approach
adopted by the two previous types of modeller, does not cater for
this. Behavioural analysis offers a useful “reality check” against the
other types of output – imagine for example the investor who professes
to be prepared to adopt a high risk stance for the potential benefits
of high reward.
Behavioural analysis will identify
whether this approach is in or out of character with that statement
and whether the investor will “sleep easy” with their decision. The
investor is presented with a series of simple statements aimed at
uncovering key soft facts, which determine how they are likely to
respond to future events. The results will help the IFA and the
investor to better understand the psychological factors likely to
impact on not just the initial asset allocation but also the
subsequent appraisal of an investment decision.
It may be that mathematically and
logically a client should be in equity based investments. They have
thirty years until they retire and no income or cashflow requirements
in the meantime. Despite the clear long-term benefits of equities over
cash, the benefits will not be any comfort to you or the client if
they can’t cope with the volatility and sell the lot the minute the
funds fall a few percentage points.
You should differentiate between
Portfolio Planners and Risk Profilers; the latter getting closer to
the client’s attitude to risk due to the client involvement in the
process and the “reality check” behavioural approach.
You may be thinking that’s fine, in a
few years time when everyone else is using these tools I can adopt
them for my practice. However, imagine you are justifying to the FSA a
sale made 4 years ago where the client’s expectations have not been
met in full and your profile states the client is a 5 on a scale of 1
to 10. You will have some issues justifying your decision but the FSA
may let it go or at least be not too harsh in their judgement of you
in that you may not have known better at the time. Now put yourself
forward another four years and you’re defending your advice process
against a client who hasn’t achieved all of their expectations. Good
luck!
With the use of automated tools clients
expectations can be managed and at the same time the adviser’s risks
reduced – certainly a powerful proposition to consider.
About Derek
Derek is a partner with The Silent Partner, a
business consultancy firm which offers direction and solutions to
businesses within the financial services sector. Derek is also
Managing Director of Strategic Asset Managers Ltd, a firm of
specialist IFAs who receive all their business from accountants,
lawyers and private client fund managers. He is a Member of the
Society of Financial Advisers.
He has over 24 years experience of the financial
services industry during which time he was Regional Director for
Sedgwick Financial Services and Sedgwick Noble Lowndes for Scotland &
Northern Ireland. He was heavily involved in the restructure of the
business over a five-year period before leaving to set up his own
businesses five years ago.
Derek also draws from his coaching background in
tennis and martial arts when coming up with innovative solutions for
business.
About Mik
Mik has 19 years experience in the
financial services industry, firstly with an IFA, then joined LSD in
1987 and helped develop it into the market-leading software for IFAs
in the late 80's.
He founded 1st Software with Rory
Curran in 1996 and is the original architect of the product, with a
continuing active roll in the design of the software and development
of new markets.
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