by Tom Williams, director The Silent Partner Limited

Tom Williams, Director, The Silent Partner Limited

Typically a client is asked to describe their attitude to risk using a scale of 1 to 10. This approach started shortly after the Financial Services Act came in and fact-find documents became more comprehensive.  However, the world has moved on and using a scale of 1 to 10 can be misleading, as it doesn’t take into account term of investment, level of income required, impact of inflation etc.

The problem is that most investors are ‘cautiously greedy’ and ask for the highest possible return, with the lowest possible risk, in the shortest possible timeframe.  These things cannot be achieved at the same time or in the same package, so how does the adviser manage the investor’s expectations into a more realistic mindset?

Among other things, Sandler in his July 2002 report, stressed the need for a better-educated consumer and proposed that a new Guide to Financial Advice should be issued to prompt the investor to ask questions of his adviser in areas of:

• Asset allocation recommendations
• Risk-return trade-off underlying the advisers’ recommendations
• Level of diversification in the portfolio split between “active” and “passive” management

A number of automated software tools are now entering the market to assist IFAs in this regard by helping them to help their clients understand the implications of asset allocation, in light of their investment objectives.  These tools do not replace the fact-find, nor do they replace the adviser; they simply underpin the process and provide an audit trail against which to base sound investment recommendations.
 
There are three component parts used in most “risk profilers” and these are “risk and reward tolerance indicators”, “stochastic modellers” and “behavioural analysis reports”.  In some instances all three are applied but more commonplace is the application of just one or two:

• Risk and reward tolerance indicators – As their name suggests these 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 – Sometimes known as probability modellers, these run 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”.
• 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.

The use of automated software tools such as those outlined above will help manage client expectations and help you attract more business.  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.
 
In summary, application of such automated tools will:

• Help to produce a much better educated investor who is far less likely to create future problems for the adviser given the robust nature of the process
• Be beneficial to future servicing reviews, which will revolve far less around performance and much more around asset risk allocation.
• Establish a more scientific basis for determining investor risk-profile, avoiding simplistic 1 to 10 analysis.
• Allow the adviser to demonstrate their professionalism and experience through use of interactive software that supports the advice process in a customer friendly manner.

About Tom

Tom Williams is a director in The Silent Partner Limited, a business consultancy that specialises in providing advice to organisations in the financial services sector.