There is a simple premise that we need to know both where we want to get to and where we need to set out from in order to reach our destination. This is particularly true when choosing to invest money.
The financial press is often accused of focusing on the negative stories that suggest consumers are not happy with the outcomes achieved from the investment of their hard-earned cash.
Pensions are a prime example of this, as illustrated by the frequency of headlines about losing money or not achieving a desired result.
In the current pension market, the wrapper is one choice to be made but the big decision relates to the contents of the wrapper, that is, the investments themselves.
The choice of investments within a pension should be linked to some form of goal and that goal will be rationalised by the amount of risk the investor can take. This presupposes the investor understands the idea of risk and can apply this understanding.
The FSA raised the idea of risk and suitability in its report, Assessing Suitability: establishing the risk a customer is willing and able to take and making a suitable investment selection’, and this was followed by the subsequent “Dear CEO letter” and thematic review.
The report looked at the suitability of investment and the need to establish a distinction between attitude to risk and capacity for loss. But do investors actually understand the concept of risk? And where they would place themselves on the risk spectrum? Is it just a case of a spectrum of one to 10, with one being absolutely risk-averse and 10 being adventurous?
Findings from research recently undertaken by Axa as part of its Wealth Self report would suggest not. The research examined consumers’ perceived investment risk appetite and then their actual appetite and the conclusion was that, for two-thirds of consumers, there is a disconnect between the two.
The study asked investors to rate their perceived attitude to risk when it comes to investments. Then, by working through a set of 14 questions, the consumers’ attitude to risk was determined on a seven-stage scale.
A profile from very cautious to adventurous was attributed to identify any disparity between perceived and actual appetite. From this, the disconnect score was calculated.
In total, 33 per cent of respondents have a stronger appetite for risk than they think and 31 per cent are less risky than they perceive themselves to be. For 64 per cent, the thought of taking risks makes them feel either nervous or uneasy, 19 per cent feel indifferent and 11 per cent say it makes them feel excited and invigorated.
The data reveals a nation that is unsure of its risk appetite. One in four consumers thought they were in the lowest risk category, representing a danger for long-term investment prospects. However, having used the risk-profiling tool, only one in 20 actually fell into this category.
The difference between perceived and actual self is critical to understand and talk through with clients. If individuals are not fully aware of how they actually feel about risk it is likely to affect their investment behaviour and, as a result, they may not meet their financial goals.
To return to my previous analogy, a successful journey has two parts – successfully arriving at the destination and the quality of the journey in getting there. How are you going to arrive at the right destination if you do not understand the way there? This could potentially be a disaster waiting to happen for perhaps as many as two-thirds of the population.
It is important that individuals are aware of the potential disconnect and take financial advice to make the most appropriate decisions for the short and long term.
The disconnect could be caused by something as simple as terminology. Do consumers really know what cautious actually means when applied to investments?
The lack of fund rebalancing could be relevant. For example, a cautious fund with a limited equity exposure could be a much riskier proposition if the equities perform well but the fund is rebalanced.
Similarly, the concept of behavioural psychology could affect how people make decisions.
There are also differences depending on age and gender. For example, in the Axa research, men overestimated their appetite for risk while women were more likely to under- estimate their risk score.
How can we address the fact that two-thirds of people could be disappointed from the outset?
Financial education is key and is required not just in the tax issues involved but also in some of the softer subjects, backed up with a robust advice process.
There is no denying that risk-profiling tools used by financial advisers are essential but they should be used as just one element.
When a client first visits an adviser, it may be they have never had to stop and think what their attitude to risk is – and not specifically in relation to their finances.
If they have not already done so, they should spend some time thinking about the concept of taking a risk, how it makes them feel and weigh this up against the sorts of returns they require from investing.
Attitude to risk should also be reviewed regularly to take changing circumstances into account.
Risk can never be an exact science and any questionnaire or other risk-profiling system can only ever provide a guide but it can bring some consistency to the process.
It can also act as a proof point for a financial adviser that can be used in future reviews in reaction to changing circumstances.
This whole area offers opportunities for IFAs, particularly after the retail distribution review when this process can be appropriately packaged and will form a key part of an adviser’s client proposition. It also leads on to the need for a complementary investment process that can reflect the agreed investment strategy and put it into practice.