Your IndustryJul 24 2013

Asking the right questions

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In the past 10 years the growth in the use of risk-profile questionnaires has been dramatic. It would be hard to argue that this has not been a good thing and of benefit to investors, but there have been a few ‘bumps in the road’.

One well-known and widely-used risk questionnaire had to be withdrawn completely as a result of the FSA’s review because it was poorly constructed and a number of advisers using it found they could not defend themselves from complaints to the Fos. Advisers have since been careful to undertake some due diligence before adopting a questionnaire.

So how does a risk questionnaire fit into the advice process? A good psychometric risk-profile questionnaire gives a statistically reliable profile of an investor’s attitude to investment risk in general at a particular point of time.

This is, of course, an excellent starting point to the advice process. However there are lots of caveats and things to consider. For example, it is well known that people generally have skewed perceptions of risk. We give dramatic outcomes much greater attention than more frequent smaller calamities. A good example is the perceived risk of flying compared to travelling by car. In both cases there is the risk of death, although far more people are killed or injured on the roads than in plane crashes, but a single plane crash, in which a great many lives can be lost, causes people to consider flying as riskier than road travel.

The private investor’s perception of investment risk is subject to similar biases. For example, large falls, (often temporary) in stock markets are given much greater attention than the steady (and normally irreversible) loss in the real value of savings due to inflation, so considerable care must be taken when interpreting the results from a questionnaire. It is important to give the investor a balanced picture and to try to help with the understanding of investment risk but, here again, care is needed. How investment issues are explained can have a strong influence on decisions.

Much work has been done by behavioural finance academics on people’s attitude to making investment decisions. How an investment choice is presented to an investor, or ‘framed’, can have a very considerable effect on his decision. For example, an investor will be more attracted to an investment presented as offering a 90 per cent chance of making some money or at least preserving capital than one described as having a 10 per cent chance of losing money, albeit that it is the same investment.

As this example illustrates, investment risk tends not to be viewed symmetrically by the private investor. Potential losses are given much greater weight generally than gains. So advisers need to be very careful not to influence their clients’ perceptions of investment risk.

Worse still investment risk is multifaceted. Even the risk of capital loss is dependent on the investor’s time frame. Then there is liquidity risk, that is not being able to sell the investment when required or the risk of poor performance due to lack of diversification. This latter risk is particularly important if an adviser is recommending a risk-rated fund.

Attitude to investment risk is only part of the picture as investors face many uncertainties that are in reality more meaningful to them as they are often the reason for investing. These can include the following:

• Not achieving an adequate income in retirement, perhaps due to poor long-term performance of investments compared to inflation,

• Failure to meet a specific investment objective. For example, repaying a mortgage.

• Capital depletion by drawing a level of income which cannot be supported by an investor’s capital.

Most of the major advice problems that have hit the headlines and involved compensation claims have arisen from failures to meet investors’ investment objectives. These include the following:

• Mortgage endowments – failure to pay off mortgages.

• Pension transfers – giving up guarantees which damaged retirement income.

• Capital erosion – drawing an income not supportable by capital.

• Short-term capital loss – failure to understand investment term objectives.

While an investor’s attitude to investment risk is a relevant factor, it is outcomes that trigger investors’ complaints and the failure to meet their expectations. The risk profile from a questionnaire does not have a tangible reality to an investor. What does being a ‘balanced’ investor really mean? Showing a benchmark asset allocation does not do it. It is only when the investor sees the likely outcomes from a chosen risk profile on an investment objective that there is full engagement.

The industry’s failure to engage effectively with investors has been the root cause of unhappiness for some investors. Communication at the outset of potential outcomes is an absolutely critical part of the advice process, and the communications must enable investors to understand the impact of these outcomes on their objectives.

As part of this process of engagement, it is vital to consider the investor’s capacity for loss. Capacity for risk is preferable as it takes full account of the impact of investment loss but also recognises that some investors might benefit from taking more investment risk, particularly in the early years of saving for retirement. While additional questions need to be asked to establish capacity for risk, this process is difficult to codify since it involves an assessment of an investor’s personal circumstances and how different investment outcomes might impact on those circumstances. The output from this step might be an adjustment to the investor’s risk profile (usually, but not invariably, downwards to a lower risk profile). It is essential to engage investors by creating credible future scenarios for them to consider.

Stochastic modelling offers a unique way of ensuring that investors are fully engaged and can ensure consistency between an investor’s risk tolerance and the recommended investment solutions. Stochastic forecasts of outcomes enable investors to understand the trade-offs that are part of achieving investment objectives.

The use of risk-rated or target risk is worrying because a single fund mapped to the output of a risk questionnaire potentially bypasses any need for serious investor engagement. When a risk-rated fund is recommended, account cannot easily be taken of specific objectives or the investor’s risk exposure from existing investments held.

A further problem is that the volatility of annual investment returns is the way the industry typically chooses to categorise the riskiness of the investment funds it offers. Annual volatility has no relevance to an investor’s objectives (for example, retirement in 20 years’ time). Essentially the investment industry has no common language to relate investor objectives to investment solutions. The result of this breakdown in communication is, unsurprisingly, frequent disappointment on the part of investors followed all too regularly by claims for compensation.

There is no doubt that the widespread use by advisers of investment of risk questionnaires is a positive development in helping to ensure that investment recommendations recognise their clients’ attitude to investment risk. However the score from a statistically validated risk questionnaire does not say anything about their clients’ investment objectives or anything directly about his personal circumstances.

The risk profile from the questionnaire provides a starting point for an informed discussion about the risks associated with investors’ objectives and the investment outcomes that might be achieved. The danger is that, because of the sophistication of a good risk questionnaire, advisers rely on it to do more than it has been designed to do.

Bruce Moss is strategy director of eValue

Key points

One well known and widely used risk questionnaire had to be withdrawn completely as a result of an FSA review.

Much work has been done by behavioural finance academics on people’s attitude to making investment decisions.

Stochastic modelling offers a unique way of ensuring that investors are fully engaged and can ensure consistency between risk tolerance and the recommended investment solutions.