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Chris Gilchrist: All roads lead to different risk outcomes

Chris Gilchrist MM blog

Thinking about the FCA’s favourite 4-letter word recently, I realised how different approaches to allocating risk profiles affect the outcome. Behavioural finance fans will not be surprised at my conclusion; that the order in which you do things matters – there is a ‘framing’ effect that many advisers use without being aware of it.

My starting point is that there are three dimensions of risk for clients – Attitude To Risk (ATR), Risk Required and Risk Capacity. ATR is NOT the client’s perception of risk, which is entirely subjective and changes with the market winds: it is their deeper, genetics-and-life formed attitude, where acting differently will give them sleepless nights. Risk Required is a derivative of the client’s objectives and needs: these translate into a required rate of return and therefore risk. Risk Capacity is, in FCA terms, the client’s ability to tolerate loss, but in financial planning terms it is also their capacity to withstand shortfalls from clearly defined needs.

Put aside for the moment the way people’s interpretation of FCA rules govern the way they design their processes. Just follow the logic of how a risk profile is allocated (and here I mean not just a description but a clearly defined asset allocation).

Say you start with ATR. There are two ways of doing this: one uses a psychometric questionnaire with a few added capacity questions, which links directly to a risk profile and a portfolio. Here there are two risks for the adviser: 1) a failure to ask questions that would reveal circumstantial constraints on capacity for risk that should be taken into account; 2) a failure to get a clear statement of client goals/needs, leading to riskier set of investments than the client needs. Using the questionnaire as just the starting point for a discussion should avoid these risks.

Starting with goals and converting these into a target rate of return and risk required, the line of questioning will then go to the client’s ability to tolerate losses/shortfalls and their attitude. Effectively, as US financial planners tend to do, the adviser will negotiate adjustments to goals in order to reach a level of risk with which the client is comfortable.

Finally, the adviser could start by analysing facts and circumstances and considering how much these constrain the client’s risk capacity. Discussion of goals/needs and attitude would follow.

Forget about any of these methods being more scientific, objective or compliant. The financial adviser is a professional whose job is weigh up each of the three factors and make a judgment. If there is a process in place for doing that, advisers should have nothing to fear from client complaints or FOS. But they ignore any of them at their peril.

Start with risk required, and they will tend to be more ambitious in terms of return – because when they are asked to articulate non-financial goals, accumulative clients tend to be more ambitious. Start with risk capacity, and there is a tendency to be more cautious, so this approach probably suits clients in decumulation rather than accumulation mode. Start with ATR, and the analysis could go anywhere, but using a process that links directly to a portfolio creates the danger of ending up with a poor compromise. It may be better than an idiot adviser would produce, but it will certainly be worse than the level required for a true professional.

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