One of the most persistent myths in financial planning is the belief that a client’s approach to investment risk determines the strategy they need.
One of the first steps many advisers undertake is to determine their client’s attitude towards risk, volatility and capital loss – their situational and psychological risk tolerance. Many advisers rely on this assessment to determine both the investment strategy most appropriate for the client and the products best suited to their preferences.
Unfortunately, this approach is fundamentally flawed and misrepresents an adviser’s legal and professional duties.
The historic practice of using risk-profiling to determine strategies and select appropriate investment portfolios – without any real consideration of the client’s other objectives, needs and circumstances – not only generates bad advice but also runs contrary to the letter and intent of the law.
Profiling and professional obligations
In financial planning, risk-profiling is generally used to construct or select an appropriately diversified portfolio that is likely to achieve the clients’ goals without exposing them to risks such as volatility, variability and capital loss with which they would not be comfortable.
Risk-profiling is a useful exercise, but it’s important to appreciate that an adviser has no explicit statutory obligation to risk-profile a client to provide suitable and appropriate advice. While assessing situational and psychological risk tolerance is important, it is not, and should not be, the primary determinant of an adviser’s recommendation.
Even the Australian Securities and Investments Commission considers a client’s attitude towards risk only one of many factors that make up the client’s relevant personal circumstances.
The purpose of profiling
If a client’s attitude towards risk is only one of their “relevant personal circumstances”, then logically, it is not, and should not be, the only factor that determines the recommendation.
If we start by acknowledging that the client’s needs are the primary considerations around which the recommendation should be constructed, their investment preferences are properly relegated to being secondary considerations. They’ll influence the direction of the strategy but they do not determine it.
Industrialised advice models might be built on the alternative proposition, but personal advice – suitable and appropriate advice – is driven by needs and goals.
In our view, it’s vitally important for advisers to understand that risk-profiling isn’t the solution to a client’s needs but simply a mechanism for initiating “meaningful discussions with clients [to] identify gaps between their objectives and the timeframe to achieve the objectives, and … undertake a transparent trade-off process”.
The Financial Ombudsman’s focus on “gaps” and “trade-offs” acknowledges, for example, that a client with a conservative investment preference may not be able to achieve their lifestyle and objectives with a conservative investment strategy.
Good advice identifies these competing needs and helps the client reconcile the divergent objectives – either by adopting a more aggressive strategy or by helping them scale back their goals to those achievable through a conservative approach.
In any event, the specific identified risks, and their effects and relevant consequences and implications, need to be explained clearly. They must also be considered, and explained, in the proper context and with sufficient reference to the client’s sophistication and experience.
Licensees and advisers may be improving their approach but we’ve seen far too many recommendations created to suit the client’s identified risk profile rather than the client’s identified needs. This has to change.
Filtering financial preferences, subjective experiences and personal objectives through a simple methodology, without applying your own professional judgement to the results, generates unsuitable advice. This is the real problem with using risk-profiling to substitute for, rather than to complement, an effective discovery process.
Sean Graham is director of Assured Support. Part two of this series will run in the December edition of Professional Planner.