The FCA’s ‘Know your customer’ guidelines encompass the requirements for financial advisers to assess their client’s attitude to risk (ATR). In it, the regulator attempts to pigeon-hole risk tolerance (which is an enduring psychological state based on a range of demographic, socio-economics and psychological factors) by means of a number of blunt, prompt based statements.
According the FCA attitude to risk – adviser prompt – the regulator appears to believe that changes in tax status, existing investments and the maturity of the investor are all factors that impact on attitude to risk. Worryingly, the FCA also believes the current economic outlook impacts on an individual’s attitude to risk. Although this is in complete contrast to peer-reviewed academic research.
If the FCA is confused and simply ignores academic research, is it any wonder financial advisers struggle to establish accurate client risk profiles? Psychometric tests have been developed to help provide more accurate outcomes but even so, obtaining accurate risk profiles still remains an elusive art.
What do we know? Based on the latest peer-reviewed research, here are the top eight things you ought to know about measuring your client’s attitude to risk:
1. Your clients ATR is stable.
You ought to ignore those who suggest ATR changes over times or – more importantly – at pension decumulation. The evidence strongly supports that risk tolerance is a stable characteristic. Risk tolerance is a genetic and predisposed personality trait that is highly unlikely to fluctuate over the life of an individual.
2. Falling or rising markets do not affect risk tolerance.
Behavioural factors can cause investors financial loss, bailing-out in falling markets, herd behaviour and mental accounting (fixing on one price) are familiar traits. Inherent risk tolerance is not affected by the general economic mood. Your clients may do crazy things, but they will be attributable to behavioural factors, not their personality trait.
3. Financial advisers are not good judges of their client’s risk tolerance.
This perhaps agrees with the regulator’s assessment of advisers and their skills of assessing their client’s attitude to risk. Most advisers rely on heuristic shortcuts and make inferred judgements about their clients. Experience, knowledge and temperament are key adviser qualities that determine accurate client risk tolerance. One study found advisers with depression were more accurate at determining client’s attitude to risk.
4. Financial advisers cause low risk scores
As alluded to above advisers are poor at determining risk tolerance and tend to use ‘rule of thumb’ methods. The representativeness heuristic is a common method used by advisers, subliminally in most cases. Based on an inaccurate sample of their own clients, advisers will incorrectly categorise a potential new client. Advantageously (for the client) the evidence suggests the heuristics cause the advisers to be biased towards low risk scores.
5. We are all equal when it comes to risk attitudes.
The evidence suggests there is no significant relationship between financial risk tolerance and gender, material status, education or wealth. Some studies have shown females are less tolerant of taking financial risks, but this is far more likely attributed to males having more knowledge about investments. As discussed previously, regardless of age, gender or wealth, those consulting with a financial adviser will have a lower risk tolerance.
6. We are low risk in the UK
To complicate matters further for those advisers who operate on a global basis and may have clients in England, United States and Australia. US citizens exhibit increased confidence in making financial decisions compared with UK or Australian citizens. An Australian citizen is prepared to take far more risk compared to his English or American colleagues.
7. Advisers don’t understand psychometric Tests
This has apparently been inferred by the FCA, evidence strongly suggests not having a good knowledge of how psychometric tests work can lead to faulty conclusions and inaccurate client assessments. Undoubtedly, testing can help towards more accurate assessments only if advisers understand how the tests work.
8. Loss aversion is more important than measuring attitude to risk.
If clients are paying for expensive cashflow plans, it is important they do not react to short-term, severe market downturns. Measuring the client’s level of risk aversion is therefore critical, therefore advisers ought to ensure any psychometric tests they use include sections on loss aversion.
Overview
In conclusion, advisers ought to use psychometric tests only if they understand how they work and accept they will use heuristics to establish their client’s attitude to risk, which will cause biases. Thankfully the biases tend to cause a lower attitude to risk.
Broadly, your clients’ risk tolerance will remain stable throughout their lives, and will not be affected directly by economic downturns or major life events. Generally, we are all the same in the UK – gender, marital status and wealth have little effect on risk tolerance.
Finally, be very careful of using FCA guidance on attitude to risk, they appear to be ignoring the peer-reviewed academic research and using inference to make their case.
Richard Bishop is a lecturer in financial services at Coventry University College and a practising regulated financial adviser
