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Phil Young: Rewriting the rulebook on attitude to risk


Born-again-Keynesian Martin Wolf recently posed the question “is there any point in saving?” to a surprised audience, which included me.

The evidence he presented was not that surprising: unless an investor is prepared to accept a reasonable level of risk to capital, there is no real rate of return to be found.

This means investing a significant percentage of a client’s portfolio in equities, which are handsomely priced for the return on risk. This is not about taking short-term tactical investment decisions; these are long-term global trends. “We’d be better off encouraging people to spend it,” he said.

Risk as a concept has been under the microscope since late 2008 but some still view it as a linear process, with every decision revolving around “attitude” to risk. How about approaching it from a different angle?

Let’s assume everyone saving has an investment objective in mind. It probably requires some “real” rate of return to beat inflation after charges and so on. Let’s say that means a 50 per cent investment in equities.

Looking at some typical attitude to risk mapped portfolios that means an average attitude to risk, compared to the norm, right down the middle at five out of 10. Having looked at the statistics on attitude to risk profiling results, about 50 per cent of those profiled have an attitude to risk which will achieve no real rate of return on an investment portfolio mapped to it.

In many cases they are being invested into those portfolios because they map to their behavioural attitude to risk. We should also remember there are those who are taking on more risk than they need to achieve their objectives.

The primacy of objectives

If we treat the client’s attitude as just another piece of information to help the adviser and give primacy to the client’s objectives instead it can drive a different outcome. To achieve a particular investment objective it may be absolutely necessary to accept greater volatility in order to reduce the risk of not achieving that goal. Note the word “risk” is applied to the likelihood of outcome not to attitude, product or fund.

Capacity for loss is a more objective test than the purely subjective deeply ingrained behaviour brought out within an attitude to risk but tough choices await. Volatility is an almost inevitable function of inflation-beating saving. Insuring against it is expensive but solutions offering this will no doubt proliferate because of demand.

Recommending a portfolio that is more volatile and with a greater capital risk than a client’s attitude suggests clearly raises the potential for complaint. At the same time it is likely, however, that such an approach is entirely correct. Doing the right thing, it appears, requires the adviser to wear some risk also.

Am I playing down the importance of attitude to risk profiling? Absolutely not. Understanding your client will be not be instinctively comfortable experiencing volatility when this is their only hope of achieving their goal is crucial in managing and coaching them through it. It is an incredibly valuable tool. But serving up a portfolio based purely on behavioural needs, which most likely will not hit the objective investment targets set, is not right either and simply defers the problem.

The job of the adviser

Much of what I have written over recent months has focused on the importance of establishing clear objectives, which allow recommendations and results to be measured. When investment returns were good, it was easy to get away with vague “saving for the long term” objectives. That is just not possible in the current economic climate and it will not be ever again.

The good news for advisers is that those who merrily make investment decisions based on their attitude to risk, with no expert advice or counselling to navigate around these issues, will undoubtedly become unstuck.

Adding a risk profiling tool to a self-directed investor website sounds obvious but could be disastrous for some. Conversely, I am informed one auto-enrolment scheme’s default “balanced” investment option has an 85 per cent equity exposure, which is certainly taking this particular bull very bravely by the horns.

The greatest impediment to successful investment is often quoted as investor behaviour; it just takes a long time to prove it. Whether it is dealing with pension freedom queries, writing a report or explaining the difference between volatility and risk, managing client behaviours to make sure they reach their goals is the difference between getting advice and investing direct.

Phil Young is managing director of Threesixty


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There are 8 comments at the moment, we would love to hear your opinion too.

  1. chris gilchrist 24th June 2015 at 1:13 pm

    I understand the US financial planner usually starts with the goals and then tells the client how much risk they need to take to achieve them; then they negotiate. UK advisers think they have been forced by regulation to start with attitude to risk but that is not so. They can and should start with goals. Then you can think about how much emphasis to place on capacity (the adviser’s objective assessment of the consequences of loss or shortfall) as opposed to attitude. In my view if the majority of your clients are capacity constrained it is a good idea for your investment advice process to emphasise capacity rather than ATR. As Phil says if you start with ATR you are likely to get solutions incapable of delivering any real return – for example the bottom 2 of any set of 10 profiles that increase equity allocation in 10% steps. What Phil doesn’t say is that for advisers on a recurring % fee, recommending a better solution – say 30% in cash and 70% in a balanced portfolio – will result in a lower recurring fee income. Adviser firms need to be aware of this conflict of interest and manage it.

  2. Trevor Goodbun 24th June 2015 at 1:32 pm

    I have to agree with what has been said here and would throw in / expand on an aspect that I think is often dealt with inappropriately and that is volatility. Many risk profilers use volatility as a proxy for risk, to my mind in direct contrast to what the regulator has said on this issue. Yes we need to talk to our clients about volatility and prepare them for it, but a portfolio that steadily loses 10% a year, year in year our will have a very low volatility. Somehow I don’t think I should be recommending that either.

  3. Eric Armstrong 24th June 2015 at 2:40 pm

    Great article and comments. Synaptic have built a risk proposition for advisers around Moody’s risk framework that sidesteps volatility bands altogether in favour of a stochastically calculated Capacity for Loss quotient. The software based jopurney starts with definition of a goal. Modern market conditions are forcing a rethink on risk / advice exactly along the lines of this article.

  4. The problem with the “start with the goals and then tell the client how much risk they have to take” stochastic modelling approach is that no-one has any idea what investment returns will be in the future, for any mixture of asset classes, over any time period. Therefore no-one has any idea what level of risk is necessary to achieve a given monetary goal.

  5. Steve Billingham 24th June 2015 at 4:29 pm

    Goals are (in my opinion) absolutely the starting point. I agree with Chris G that capacity is more relevant than attitude and as Chris has said in the past, that is a matter of professional judgement based on answers to the questionnaires and a discussion with the client.

    This is actually about Investment suitability, not attitude to risk. Having been the victim of a number of different ATR questionnaires I find the psychometric nature of the questions serve to confuse clients rather than engage them in an informative conversation based on relevant questions which they can understand and which provide genuine context about “investment suitability”.

    “Investment suitability” is also a far less worrying topic to discuss with clients than “risk” and will deliver a better client experience in my view.

  6. Phil raises a number of important issues of this topic.

    The client’s investment objectives are paramount; as Phil says, the adviser and this really means the advisory process as a whole, should give primacy to the client’s objectives. So how important is attitude to risk within this context? In my opinion, not very high at all and very secondary to other investment criteria such as timescales and potential drawdown needs.

    If ATR is the least important factor in determining an investor’s suitability, why does it seem to dominate the debate? Investment suitability is not the same as ATR. COBS9 is all about suitability not about risk profiling.

  7. An excellent article and debate. I agree that the client’ objectives need to be paramount. However, if a client’s objectives can’t be met based on their CFL and ATR, I would suggest that it isn’t just a case of saying to a client “you need to take more risk”. Particularly for the reasons cited by Sascha KlauB. There is also a conversation to be had about them a) saving and investing more and living a more modest lifestyle now b) living a more modest lifestyle later in life and 3) working/saving for longer. Then the client faces a choice. Also, people new to investing are likely to be more cautious as they are entering the unknown, so it might be worthwhile letting the strategy initially reflect that until such time as their experience has more depth.

  8. Matthew Rodhouse 29th June 2015 at 10:23 am

    The FSA commented on this issue in paragraphs 4.9 to 4.13 of their Finalised Guidance “Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection” dated March 2011. Paragraph 4.10 requires a detailed discussion with the client, including the implications of trade-off decisions which act as an alternative to higher risk investments (e.g. “saving more, spending less, retiring later”). Paragraph 4.11 states that “where the customer does not have the capacity to sustain the potential loss of a higher risk strategy, the firm should explain that the customer’s need for a higher return cannot realistically be met”. This seems to me that the client might have to change his/her objectives in certain circumstances and thus shows that they are not paramount. The adviser needs to give advice which is suitable given all the circumstances of the client and this includes telling the client in certain circumstances that the client’s objectives are probably unachievable and he/she should plan for more limited objectives.

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