The question: Smith Jones Financial Planning is reviewing its processes and advice standards for deciding its clients’ risk profiles and the resulting asset allocations for clients’ investment portfolios. Smith Jones, like many firms, has made a lot of progress towards establishing common processes but still has some way to go. Advisers have all used the same psychometric test for clients’ risk tolerance and broadly the same criteria for determining clients’ capacity for loss. But the senior management team feels that the processes could bear further scrutiny to achieve a better and more consistent set of outcomes.
The solution: The risk committee is the first port of call for reviewing these processes. The compliance officer asked the risk committee to read the relevant section of Taxbriefs Advantage before the meeting.
The risk committee first listed the key areas they felt needed review. These included:
- Defining and quantifying each client’s aims and objectives. There were lots of tricky aspects to this but it was agreed that the best way to explore these issues was likely to be with the help of lifetime cash flow modelling. Of all the planning tools, this is emerging as the most central.
- The level of investment risk clients would need to accept to meet their investment goals with a given level of resources – what might be called target risk (although some American financial planners confusingly call it ‘capacity for risk’).
- Psychometric testing – which one to use and how to interpret it and discuss the outcome with clients.
- The importance of clients’ experience and understanding of investing and how best to categorise this and take it into account.
- The extent to which clients should be encouraged to set up different compartments for different objectives and the advantages and dangers of this ‘mental accounting’ approach.
- The difference between risk tolerance – essentially clients’ emotional ability to cope with the ups and downs of the investment markets – and their capacity to take on risk, which is related to more objective factors such as their income, wealth and investment timescale.
- The interaction between the level of target risk needed to achieve the client’s objectives and their risk tolerance and capacity for loss. In some cases, clients hold plenty of assets and can afford to take less risk than they might think and still meet their needs. But for all too many clients, there is a shortfall. So the level of risk they need to accept to provide them with enough retirement income, for example, may be far higher than they can tolerate or afford to take. They then have to lower their goals or decide to save more.
- The way in which the fact finding process should lead to an asset allocation decision.
- How best to record all this information and report back to the client in a comprehensible way.
Measuring capacity for loss
One of the most interesting discussions from the meeting revolved around the issue of capacity for loss.
How could you measure it and was there some kind of objective standard?
One adviser recalled a description of risk tolerance and capacity for loss that illustrated how the two terms can be completely uncorrelated.
A seriously rich person might be terrified of incurring any losses (a very low psychological tolerance of investment risk) but this person could clearly afford to sustain a loss of several thousand pounds with no material consequences for their wealth or spending powers (a high capacity for loss).
In contrast a very poor person would be very seriously affected by the loss of a couple of thousand pounds (low capacity for loss) but might be desperate to punt all that they have on penny shares and race horses (high psychological tolerance of risk).
The very cautious, rich investor might need help to see that diversification would probably lead to overall greater protection against loss, even if this involved losses for individual parts of their portfolio.
If such an investor rejected this attempt at education, it would be important to respect their view. On the other hand, poverty-stricken gamblers need defending from themselves.
The Smith Jones Financial Planning risk committee agreed that most people are not at such extreme ends of the huge spectrum.
But clients need help to envisage what investment losses might feel like and how losses might impact on their overall financial position by using well-constructed long term cashflow planning.
Danby Bloch is Editorial Director of Taxbriefs Financial Publishing
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