A better understanding of risk will help clients make more money, according to Nick Bullman, founder and managing director of the London-based risk consultancy, CheckRisk.
Understanding a client’s risk tolerance has traditionally been used by financial planners to help clients avoid taking unnecessary risks.
But Bullman says there are times when it is absolutely necessary for clients to take on risk – sometimes a lot of risk – and it’s the adviser’s job to understand when taking that risk is likely to be adequately rewarded.
“When people consider risk, they often think about what it stops them from doing,” Bullman says.
“There’s this preconception that if you’re paying attention to risk, you can’t do certain things; it just constricts you choices.
“But understanding risk means do you understand the equation, are you being paid to take risk at the moment? In that environment, risk may be a real positive. In other words, there are times in the market when it’s absolutely essential to take excess risk, because you’re being paid to do so.
“There are times when you just shouldn’t, as well.”
Where the cutting edge is
Bullman says modern-portfolio theory (MPT) is based on the idea that all investors are rational and that as a result markets are efficient. But Bullman disputes the efficient-markets hypothesis, simply because people are not rational and human behaviour drives much of what happens in markets.
“Modern-portfolio theory, value at risk [VAR] – a lot of the risk systems – are based in this idea that all investors are rational,” he says.
The fact is that the efficient-markets hypothesis simply doesn’t work. And modern-portfolio theory, in our opinion, doesn’t work either,” he says.
“Value at risk certainly doesn’t work – and you can ask anyone at some of the big banks that have lost huge amounts of money that were using value at risk – for proof-positive of that.
“The point is that it will take time for academia to accept that behavioural finance has a role to play. It will take time for people to understand that we’ve got to look at risk in a different way.
“But investors don’t have to wait. That’s just academia and the regulators taking time to catch up with where the cutting edge is.”
