This second article of a two-part series on risk-profiling explains why advisers’ approach to risk may be wrong. Read part one here.
As compliance experts, we understand that a client’s investment preferences, capabilities and needs are used for a variety of purposes, including strategy development, asset allocation, portfolio construction and product selection.
We know that appropriate investment advice is built on the foundation of the adviser’s solid understanding of their clients’ appetite for, and tolerance of, investment risk.
We accept that informed consent requires the client to understand, and accept, the risks involved in implementing the recommended strategy.
We understand that the industry is working hard to reconcile professional obligations and commercial needs but we are concerned that the retail advice industry has spent too much time and effort on classifying and disclosing generic risks, and not enough on addressing the ‘real’ risks with which most consumers are concerned.
We believe consumers care less about outperformance and the technical aspects of currency, market and operational risks, and more about the real likelihood of full or partial capital loss.
Too often, advice that we’re asked to review fails to clearly or effectively address the likelihood, and potential impact, of capital loss.
This is not a disclosure issue, nor is it a compliance issue. It’s a professional challenge for an industry wedded to boilerplate templates and advice systems.
If advisers and licensees want to avoid client complaints, they need to more effectively communicate to their clients that every investment – from a term deposit to an international hedge fund – involves a risk that some or all of the capital might be lost, that the returns might be inconsistent from time to time or that the value of the asset might vary greatly over the period of investment.
To those who assert that this is already done, we answer that while it may be done by some, it’s not done by all, and it’s generally not done well. In our view, burying real risks in a static, bloated and impenetrable advice document doesn’t address the substance of an adviser’s professional duty.
Advisers should embrace both empathy and engagement and remember that their duty to consider, communicate and manage investment risks is an ongoing responsibility; it requires them to consider their client’s investment preferences, and the relevant product and market risks, regularly.
Disclosing product and market risks
Traditionally, advisers and licensees have sought to address investment risk through a belts-and-bracers approach to disclosure. Their advice considers currency risks and the chance that legislation may change, companies collapse and markets capitulate.
The problem with this specific approach is that, rather than protecting the adviser and equipping the client to make an informed decision about the recommendation, it trivialises risks and reduces comprehension.
The practical limitations of this approach were highlighted in Queensland District Court Judge Douglas J. McGill’s 2008 opinion in Evans & Ors v Brannelly & Ors. McGill wrote that:
“The difficulty…is that although the [disclosure document] referred to a large number of risk factors, they were referred to in very general terms, in terms which suggested that what was being spoken about were essentially theoretical risk factors. This is best illustrated by the fact that they extended to matters such as ‘employment levels, government policies, and the general state of the Australian or local economy might affect the performance of the development.’ Saying this sort of thing to an unsophisticated potential investor is essentially meaningless.”
Disclosure is not an acceptable alternative to your professional judgement. If you’re an adviser struggling to reconcile these clear principles with your compliance requirements, please remember that less is more effective.
Some risk profilers believe that a person’s preferences – both their willingness to take on risk and their tolerance of volatility and variability of returns – are a static measure. But our view, consistent with the Financial Ombudsman Service’s determinations and behavioural psychology, is that a person’s investment preferences are fluid, contextual and experiential.
Investment preferences will move and change over time. The abiding value of an ongoing advice relationship is that the client’s portfolio and exposure can be adapted to changes to their circumstances, needs and preferences.
Both intuition and anecdotes suggest that investors tend to be more aggressive when markets perform well and less aggressive when markets are down. When a highly geared portfolio is consistently outperforming the market, investors are generally less concerned about the portfolio’s inherent risks than they are after the market crashes.
The real challenge for an adviser is to assess a client’s tolerance of risk accurately, based on both prospective and retrospective measures.
“Consistent with other recent findings, we found evidence that risk-taking behaviour is a situation-specific behaviour, not a general personality trait.” James E. Corter and Yuh-Jia Chen wrote in the Journal of Business and Psychology.
Regardless of the profiling tool used, it’s important to appreciate that a person’s approach to investment risk is coloured by their personal experience and is, in fact, highly subjective.
Cleave to context
“We find that both retail and institutional investor inflows and outflows strongly chase past raw performance but, more importantly, they do so without regard to risk,” Christopher P. Clifford, Jon A. Fulkerson, Bradford D. Jordan, and Steve R. Waldman wrote in 2011 in, “Do Investors Care About Risk? Evidence from Mutual Fund Flows”.
Reasonable, suitable and appropriate advice should address investment risk clearly and effectively.
It’s difficult, if not impossible, to secure a client’s informed consent without openly addressing capital security and the variability and volatility of returns. These conversations may be occurring but, too often, risk appetite and tolerance is assessed by reference to generic factors, such as inflation and investment horizons, rather than by reference to that client’s specific needs, circumstances and experience.
The law supports the proposition that advisers should cleave to context. The adviser’s key failure was not their risk-profiling process but their manifest failure to communicate clearly what the assessment meant for the client and how it would affect portfolio construction, asset selection, their capital and their return on investment. This is not a technical issue but a profound advice failure that provides the client with no explanation of answers obtained.
An adviser should identify and address in their Statement of Advice the specific risks that, in their experience and based on their research, present a material danger to the client’s capital or affect the likelihood that clients will achieve their goals.
Academic research suggests that investors generally chase performance and ignore risk, but when potential risks crystallise, client preferences often (retrospectively) change and the adviser is left to rationalise, defend and explain their choices.
Specificity, clarity and context are critical. As a wise man once said, “Universal law is for lackeys. Context is for kings.”