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Risk profiling: Psychological conditions

Chris Gilchrist

A few weeks ago, I wrote about the perils of risk profiling, so I was pleased to read the FSA paper that identified lots of short-comings in risk-profiling tools as well as in their users. Some of these are obvious but the FSA’s prescriptions have scary implications for advisers and product providers.

To start with the obvious, someone’s stated preferences about risk and their under-lying attitudes to risk, as revealed by psychometric questionnaires, do not necessarily correspond with their capacity for risk.

This is determined mainly by objective factors such as their resources, age, health and expectations. The FSA rules say advisers must take risk capacity into account in making recommendations. Many do not. As I remarked before, if you go straight from the answers to a psychological questionnaire to a portfolio, you may omit consideration of capacity and therefore give bad advice. The FSA has just given a wake-up call.

In my view, the psychometric questionnaire is an ingenious ancillary tool but it is a recent invention. Before it existed, advisers assessed risk capacity either explicitly or implicitly. They just need to put the horse back in front of the cart. Objective factors should always outweigh subjective ones in the advice-generating process.

A secondary point is that where capacity is the key issue, then probabilistic assessment of loss is inappropriate. To put it another way, if you have limited risk capacity, then it does not matter that the percentage of loss with an investment is small. What the adviser has to focus on is the consequences of a loss. Warren Buffett puts it like this: “A small chance of distress or disgrace cannot be offset by a large chance of extra returns.”

Those who recommend structured products often, in my view, fall into this trap. They do not consider the awful consequences of a loss (as with Lehman-backed structured products) because they are misled by the probabilities.

Back to the main issue. Tools that create portfolios can use attitudes to risk derived from questionnaires but measuring someone’s risk capacity with a few questions is much more difficult. Some creators of risk-profiling tools such as Oxford Research & Analysis are aware of this issue and are working on solutions.

Even if they succeed, the FSA paper makes creating usable tools harder. Quite rightly, it says advisers who use such tools must understand their construction and assumptions. In the case of tools that use stochastic processes to gener-ate portfolios, I would guess that eliminates about three-quarters of advisers. I think you can only really understand these tools and explain their output without the risk of misleading a client if you understand the portfolio theory on which they are based. And portfolio theory is not easy – I would argue that it requires A-level maths or better. So bigger, better black boxes are effectively ruled out. Perhaps simplicity will get a look in.

Since the FSA leans towards interpreting risk capacity as the ability to withstand losses, it may be that drawdown (the maximum historic peak to trough loss over relevant time periods) is a better measure of capacity. That will raise another set of tricky technical issues.

You can argue that trying to make investment advice more scientific is doomed by the uncertainty that prevails but well designed tools could at least reduce the frequency of bad investment advice, which would be a good outcome.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. What this article fails to mention is the difference between a paper loss and a loss on encashment. The crux of the issue is that the risk of loss on encashment diminishes according to the length of time for which a portfolio of investments is held, notwithstanding a few paper losses along the way. Thus, a portfolio vulnerable to periodic fluctuations in its face value is unlikely to be suitable for someone with a specific encashment date in mind, particularly if that date is only a few years in the future. But, for the true medium to long term investor with no set encashment date in mind, a few negative valuations along the way are unlikely to be of any great consequence.

    Most inexperienced investors want investments that only ever head in one direction from the word go, or which at least offer a capital guarantee at some not very distant set maturity date. That is why so many bank clients are lulled into the misconception of having been given appropriate advice when they’re sold a fixed term capital guaranteed life assurance investment bond. The charges may be heavy, the taxes that onshore life funds incur may be avoidable and the underlying fund is usually a brand new managed fund with no track record that ends up delivering extremely lacklustre returns but, provided any mention of those drawbacks is carefully avoided, it sounds like a pretty good package.

    The danger for advisers trying to steer their clients towards investments likely to achieve significantly better returns than cash or some cheesy managed life funds is failing to explain that paper losses along the way do not mean the investment has been a bad one.

    The key message that needs to be conveyed is that volatility and risk of capital loss are not the same thing and for that you don’t need a sophisticated risk profiling tool.

  2. It is good to see the FSA and commentators beginning to question the use of risk-profiling tools for risk assessment.
    The great difficulty, and one of the key reasons for the growth of these dubious tools has been the slavish attitude of the FSA that ‘if it isn’t written down it didn’t happen’
    I strongly agree that an objective assessment by an experienced adviser is the essence of risk profiling.
    Come the RDR however much of that experience will be dessimated and lost to the industry for ever. To be replaced with over qualified computer operators looking for an easy mathematical solution to human nature. They WILL fail. And so will the FSA!
    When a client suffers a short term, possibly temporary, fall in his investments he is unhappy. Whether or not the original advice was ‘suitable’ If he is then told that he can recover his losses by complaining to the FOS with the backing of the FSCS, then he will understandably leap onto the opportunity.
    The only protection for the IFA is to somehow document the reasons for his advice. Objective views fail this test. and so to Risk Profiling tools as the panacea – not for the client – but for the protection of the salesperson.

  3. Chris talks a lot of sense. (Am I allowed to say that?) When I have been to IFAs one of the questions I’ve always been asked is “What is your attitude to risk?” As a native English speaker I understand the question, but as a consumer it’s somewhere between meaningless and confusing. More broadly, as a consumer, what has the FSA ever done for me?

  4. Investing for the future is a “journey risk” but as long as the customer understands that there will be peaks and troughs in performance over that timeframe there should be no reason why any complaint about short term performance would be upheld. The IFA community are being reminded that they are not stock pickers – fund performance is down to the fund manager and his/ her resource to make the underlying investment decisions. The IFA’s role is to manage the volatility risk of the investment(s) recommended – simples!!!

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