The Conexus Institute's David Bell (Image: TS)

Work is underway to create a standardised approach to growth/defensive asset classification that can be applied across the financial services industry. Hopefully the advice industry won’t let that end the discussion around how to define and measure risk. Rather it should prompt the exciting discussion around enhancing the way we define, measure and communicate risk.

Growth/defensive classification is embedded across different segments of the financial services industry. It is used in APRA’s Heatmaps for assessing super funds, it forms the basis of peer groups created by research houses, and is a common part of the financial planning process.

Growth/defensive is entrenched in industry yet nearly everyone agrees it is not the best measure of exposure or risk. To be honest it never will be, but we can improve the measure by making it standardised and well-considered, and removing much of the subjectivity which has reduced industry confidence in performance analysis.

Let’s clean it up the best we can and move on. You can help by contributing to the consultation.

With an industry standard resolved we can then move to the exciting consideration of how to measure risk through an advice lens. Growth/defensive exposure may well get disclosed to clients, but from here the canvas is yours, and it is a blank canvas. What a fascinating opportunity.

For me the issue is context, or what I call contextual risk management. This is about the circumstances faced by your client, their goals and associated timeframes, and how they value different outcomes. Let’s explore an example. An HNW adviser provided feedback on our growth/defensive work that many of their clients are retired and have significant wealth, and that the aim of their clients is to live off the income stream derived from their investments with the mark-to-market volatility effectively borne by those in line for bequests. (We will leave for another day to debate if that is the best strategy given it penalises low income growth opportunities).

In this context the HNW adviser argued that the primary risk measure should be based on stability of income. It is hard to argue with this – sound logic in this context. Note the use of the word ‘primary’: most risk managers would advocate the use of multiple risk measures. I often think of an investment as an object on a dark stage: one spotlight may provide some insight but multiple, different spotlights are likely to provide far greater insight. So multiple risk measures but maybe a primary measure which drives the investment plan decision.

There are a number of interesting reflections on this world of standardised disclosure (growth/defensive) and contextual risk management.

First, the primary risk metric will logically differ across client types based on their circumstances. This means that firms specialising in different client-types will use different risk measures. Some firms which work across varying client types may need multiple primary risk measures and as a result their processes are more complex.

Second, risk and return interact in the context of achieving outcomes. The basis for adopting a higher risk strategy is that the accompanying expectation of higher returns improves the range of outcomes relative to goals. But are expected returns constant through time? If you think not (I’m in this camp) then the mapping of clients based on their circumstances and risk profiles also should change through time.

Third, consider the ramifications for planning software. The day and age of basic risk profile questionnaires and a simple static mapping to a growth/defensive portfolio are hopefully well behind the industry. Using metrics appropriate to the circumstances detailed by the client will be all important.

And finally, communication skills remain ever-crucial: explaining to clients that in some circumstances taking more risk (as measured by growth/defensive) is the most appropriate strategy is a conversation which requires skill.

Rather than an anchor, sorting out growth/defensive is a release valve. Embracing a contextual risk management mindset to incorporate the circumstances and goals of the client, developing the appropriate risk framework, constructing a portfolio plan to deal with risk and then communicating all of this to clients is a fantastic opportunity, and one that should be embraced.