In my last column I said that ‘How much can you afford to lose?’ ought to be the starting point of a process to deliver investment recommendations.
Several readers have pointed out that the client cannot answer this question. I agree: it’s a question the adviser has to answer, because capacity for loss is a professional judgement, not a fact.
I do not see this as a problem. On the contrary, it is where advisers’ value lies in the investment process – their ability to interpret circumstances, goals and attitudes to deliver a satisfactory investment outcome.
I have seen risk questionnaires where, after a set of attitudinal questions, there is a question along the lines of ‘What is the maximum percentage you could afford to lose?’ which is taken as the ultimate determinant of risk profile and asset allocation. This is nonsense.
If you ask the client, you get an uninformed attitudinal answer, because the vast majority of clients cannot relate a loss to their circumstances in such a way as to understand the consequences.
An attitudinal questionnaire may deliver a reliable output in terms of a personality profile. But it is not predictive. I am a calm and tolerant person, but this does not predict my response to any specific occasion on which someone is chattering loudly on their phone in the quiet carriage.
Someone with an apparently high tolerance of volatility may respond with irrational panic to a crash simply because of the coincidence of personal and other circumstances. A generic prediction that in nine out of 10 crashes an investment client will be calm and rational is not one I find useful.
Assessing capacity for loss is an analytic exercise. It requires the adviser to know about a set of important circumstances for the client. Usually, some enable the client to withstand losses while others make them more vulnerable.
Many advisers probably run heuristics along the lines of ‘good health > greater capacity, poor health > lesser capacity’, ‘secure income > greater capacity, insecure income > lesser capacity’, ’large expectations of capital > greater capacity’ and so forth.
In my view, it is impossible to construct a questionnaire that captures all possible relevant circumstances and weights them to give an overall assessment of capacity. There are too many circumstances and they interact in too many ways.
However, you can construct a questionnaire like Harbour, which includes questions that affect capacity for all clients – for example, the amount of capital held outside the proposed investments, the percentage of total income that will be derived from investments, and liquidity/access requirements. An adviser can use this to set an appropriate asset allocation.
Since the main problem with capacity is that advisers often deal with it differently, constructing a questionnaire where scoring delivers an indicative output in terms of asset allocation is an essential control tool for owners of adviser firms. There should be clear documentation of the reasons for deviation from this – identifying which circumstances are relevant and why.
If all this is ‘played back’ to the client, they should have clear understanding of why the recommended solution is suitable. And the adviser firm should have solid records to justify its advice at any point in time, provided of course that client assessments are regularly reviewed.
Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits The IRS Report