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Balancing the scales of risk

Operating in an increasingly regulated climate has already put many burdens on adviser firms, not least with the rise in associated costs.

Mitigating the risks within a business can help reduce the worries of regulation but, ultimately, the solution must lie with reducing the risks associated with providing advice.

We put this theory to the test when we researched advisers on their attitudes to risk. Seventy-three per cent said they were very concerned about their clients&#39 understanding of risk and 24 per cent said they were somewhat concerned.

This left only 3 per cent of advisers with no concerns about assessing and taking all the responsibility for their clients&#39 understanding of risk.

For the past 15-20 years, 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, assessing risk on a scale of 1-10 takes no account of time. A balanced managed fund may be regarded as a five but what if the client was only investing for three years and was taking a 5 per cent 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.

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?

More sophisticated systems are required to ensure a greater chance of the client being comfortable with the risk •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.

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 1-10 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 affect 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 30 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 cannot cope with the volatility and sell the lot the minute the funds fall by a few percentage points.

You should differentiate between portfolio planners and risk profilers – the latter getting closer to the client&#39s attitude to risk thanks to client involvement in the process and the reality check behavioural approach.

You may be thinking that is fine. In a few years&#39 time when everyone else is using these tools, I can adopt them for my practice. However, imagine that you are justifying to the FSA a sale made four years ago where the client&#39s expectations have not been met in full and your profile states that the client is a five on a scale of 1-10.

You will have some issues justifying your decision but the FSA may let it go or at least not be too harsh in its judgement of you in that you may not have known better at the time.

Now put yourself forward another four years and you are defending your advice process against a client who has not achieved all their expectations. Good luck.

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