The Financial Ombudsman Service recently published some investment case studies relating to client attitude to risk.
The majority of the complaints it has highlighted involved customers who had wanted low risk investments but were advised to invest in higher risk funds. Some of these involved advice from banks and building societies, but three of them involved financial advisers.
One of these complaints was not upheld, the reason being that the adviser had documented his conversations with the customer and could show they had discussed what an “adventurous” attitude to risk could mean in terms of the risk to the customer’s capital.
However the other two complaints were upheld and do not show the advisers concerned in a good light.
For example, one case involved the use of an attitude to risk tool where the customer had scored “between three and four on a seven-point risk scale” (where seven was the highest level of risk and one was the lowest) but was recommended a portfolio which was invested 100 per cent in equities. Ouch!
One way of dealing with this disconnect (between the output from a tool and what the customer ends up investing in) is to get the industry to agree on a standard way to measure risk and what this means in terms of asset allocation.
At a practical level, our advice process must make do with the tools that we have been given. The rise in use of the model portfolio, or centralised investment propositions, is an attempt by the industry to provide a consistent, repeatable process which is affordable for the customer and profitable for the adviser to deliver. Statistics from platforms and life companies support the view that these are very popular.
So now we have lots of risk profiling tools which align to lots of different model portfolios.
A customer who scores “balanced” on one tool could also score “moderately cautious” on another tool. And they may well end up with a different asset allocation depending on which tool and set of model portfolios is the preferred option of the adviser. It is also possible that they could end up in a very similar asset allocation, if different sets of model portfolios are being used.
At first glance this does seem a bit suspect. However it is probably satisfactory, provided the adviser understands the tool being used and can explain what “balanced” actually means, in terms of the risk the customer is taking and what a bad outcome might look like.
In order to do that, advisers must understand what the attitude to risk tool is – and is not – doing. But advisers must also recognise that it is just one corner of the risk triangle. Advisers also need to consider capacity for loss and the financial needs of the customer.
Generally speaking, the greater the customer’s wealth and income (relative to any liabilities they have) and the longer their investment horizon, the more able they will be to take investment risk and the greater their capacity for loss.
Consideration of these issues should be a key part of the financial planning process.
Risk attitude, on the other hand, is more about the customer’s psychology than their financial circumstances. Some individuals will find the prospect of volatility in their investments, and the chance of losses, distressing to think about. Others will be more relaxed about those issues.
Both of these issues (volatility and chance of loss) should be balanced against the customer’s need to take investment risk in order to meet their financial goals.
Typically we need to take risk to make higher returns. However, some customers might not be comfortable with this and may prefer to adjust their goals. They also need to understand that not taking enough risk could mean that their investments don’t deliver the desired growth, or even keep pace with inflation.
ATR tools are unlikely to capture all of this; in fact some only score risk attitude. So it is really important that advisers do understand the limitations of the tool they are using.
It is even more important that providers of ATR tools give clear information about what their tool delivers, and what it does not.
Most advisers already understand that the output from a tool is simply the trigger for the adviser and customer to sit down together and discuss the desired financial goals clearly, so there is clarity about the amount of risk the customer is comfortable with and the investment implications.
This can sometimes lead to a change in risk category, which is fine as long as it is documented. If this is done correctly, if the FOS come calling, the adviser can show that the issues were explained to the customer at the point of sale
In the end, regardless of how many tools are built, it is still vital to include the principles of good, old fashioned advice.
Lorna Blyth is investment marketing manager at Scottish Life
Financial Ombudsman Service case study
Mr C had built up £65,000 in savings.
When he mentioned to his sister that he wanted to invest some of the money, she gave him the phone number of a financial adviser she had used in the past.
During the meeting the adviser asked Mr C how he felt about taking a risk with his money. She explained that if he was willing to take some risk he might have a chance of getting more growth on his money.
Mr C told the adviser that he was interested in getting more growth, but he said that he wasn’t too sure because he hadn’t invested any money before. He agreed to answer some more questions about his attitude to investment risk to help the adviser work out which investments might be right for him.
The adviser told him that based on the answers he had given, she rated his attitude to taking risk with his money as “between three and four on a seven-point risk scale” – on which seven was the highest level of risk and one was the lowest level.
The adviser recommended that Mr C invest £30,000 in a range of investment funds. She explained that the funds would be chosen using a computer-based tool designed to “select and blend” investment funds.
Mr C went ahead with the investment. More that three quarters of the £30,000 was invested in shares on the stock market in the UK and overseas. Most of the rest was put into commodity funds investing in oil, gold and agriculture.
Each year, Mr C received an annual statement for his investments. By the fourth year, his statement showed that their value had dropped considerably. Mr C was concerned that he had made a serious mistake, and he complained to his adviser.
The adviser told Mr C that he shouldn’t do anything at this stage – because they were supposed to be long-term investments and there was still a chance that they would perform better in the future. But Mr C was still concerned by the drop in value, so he brought his complaint to the FOS.
FOS response: Complaint upheld
When we spoke to the adviser, she pointed out that Mr C had been prepared to take some risk to get a better return on his money. However, when we looked at the detail of the investments – and compared them with the adviser’s notes about Mr C’s attitude to risk – we were satisfied that the adviser had taken more risk with Mr C’s money than he had told her he wanted to take.
We accepted that the computer-based selection tool the adviser had used was standard across the investment world. But we took the view that the adviser had still been responsible for making sure the funds she had advised Mr C to invest in were appropriate for his particular circumstances.