In the UK, confidence in financial advice has grown steadily over recent years. Core to that improvement has been a strong commitment to suitable personal advice with risk profiling central. In contrast, in Australia, confidence by consumers in the advice industry is hovering at a low and most people won’t go near a financial adviser.

The Storm fiasco would have been extremely unlikely if there had been an obligation to take into account an individual’s risk tolerance. Borrowing to invest is beyond the risk tolerance of virtually all investors, except for those whose hobbies include running hedge funds, a characteristic rarely found in North Queensland’s retirees.

In addition, if the advisers at the centre of the scandal had asked a question along the following lines, there would have been very different advice. “Margin lending is higher risk than you are naturally comfortable with given your risk tolerance. Are you happy to proceed knowing that you might lose your house?”

Moreover it was, and remains, well known that margin calls are badly managed in a severe market correction. It’s also common knowledge that banks enforce their rights. No informed retiree would likely have proceeded with even single gearing let alone double gearing (borrowing against the house to provide the foundation investments for a margin loan) if they knew the risks and possible outcomes included loss of their home.

The need for risk profiling guidelines

Most successful financial businesses grow from the application of sensible regulatory standards and the use of quality tools. Unfortunately, neither are prevalent in Australian advice.

I regularly hear of major Australian banks and industry superannuation funds using and planning to introduce short, non-psychometric tests, sometimes having as few as four or five questions. The mind-set that allows for such behaviour goes to the heart of the problems that undermine confidence in Australian financial advice. This is clients’ interests playing second fiddle to business ‘efficiency’.

Risk profiling failures are symptomatic of the lack of personalisation that contributes to current industry issues. For instance, loss of confidence results in clients parting company with banks, their advisers and industry funds and ‘home building’ high-risk portfolios often inconsistent with their needs and outside their risk tolerance. This is evidenced by the self managed superannuation fund (SMSF) tinderbox which reveals globally unrivalled levels of risk taken by a growing community of over confident, anti-establishment and local market focused investors.

The only practical way forward, without appropriate regulation, is self-regulation. One adviser, one advisory firm, and, dare we hope, one bank and one industry fund at a time.

(In)different risk profiling approaches

Virtually all risk tests used in Australia are non-psychometric. This means that they do not adhere to an international scientific standard. Their results are neither valid nor reliable. It’s often just a make-up exercise, which is consistent with the tick-a-box culture that pervades much of the advice given in Australia by many larger enterprises.

If a risk tolerance test is not psychometric, it’s difficult to know what it measures. Many tests we have looked at include questions that refer to other factors, which do not relate to the personality trait that’s an individual’s financial risk tolerance.

These might include questions relating to investment time horizon and the client’s capacity for loss. Inclusion of such questions will obviously increase the number in the test, usually to the detriment of the final output as they introduce factors irrelevant to the assessment of risk tolerance.

Regulatory obligation

There’s nothing new in an adviser’s obligation to take into account a client’s risk tolerance in FoFA. The actual obligation can be found in RG 175, para 287. RG 175 has been around, with a different nomenclature, for more than ten years.

It’s rarely taken seriously, and even more rarely has it been enforced. To the best of my knowledge, it’s never been brought up to date and remains as ambiguous as it was when originally introduced. It’s a long way from the more useful formulations in other jurisdictions.

Consideration of a client’s risk tolerance in the advice process is essential to the creation of confidence in planning. Australian investors, and their advisors, deserve first-rate services and tools. In the absence of regulatory intervention, it will be those that choose the more challenging professional path of self-regulation who will succeed. For those interested, the client focussed UK regulation is a good example of a successful formulation of investment suitability.