Your Industry  

Poor practice harms risk-profiling industry

Poor practice harms risk-profiling industry

First of all, bravo! At last someone other than FinaMetrica has come out and condemned the use of poor risk profiling tools.

As Richard Bishop stated in his article of 25 January, in 2011 “the regulator concluded that 50 per cent of clients suffered misaligned risk profiles and strongly advised firms to understand the limitations of risk-profiling/asset allocation tools.

“Of 11 tools reviewed, the regulator found that nine had serious weaknesses and led to flawed outputs.”

Article continues after advert

What Richard did not say was that because the regulator refused to name the two profilers that passed muster, all 11 profilers in the market claimed they were one of the two.

Consequently no adviser was obliged to review past advice, few profilers amended their offerings and the merry charade of unsuitable offerings continued unabated.

We agree with Richard. A good financial plan should work towards making assets available to meet clients’ liabilities as they fall due. This has two behavioural parts.

How might the portfolio respond? And how might the client in turn respond when markets move?

When markets are booming does the client correspondingly increase spending? Or when they are in decline, can the client modify their spending?

Both parts can be managed through the development of a comprehensive investment policy statement based on ‘what if?’ cash-flow goals-based planning. But how many advisers do that?

A good risk profiler will provide a long enough back history to frame clients’ investment expectations. While the past is no precursor of the future we do know that the sun rose today, yesterday and the day before. There is a good chance it will rise again tomorrow.

As Richard points out ‘Inflationary, liquidity and the crucial macro-economic risks must be included in the risk assessment.’ As such, the scenario testing used by large enterprises should also be available to retail advisers and their clients.

Where I disagree with Richard — and this will come as a surprise to absolutely nobody — is his contention that all risk profilers are useless.

They are quite clearly not. Richard’s approach to evaluating an investor’s risk profile is paternalistic and relies on the obedience, or worse still, acquiescence of the client. This is dangerous and naive.

It leaves all the liability with the adviser. The ‘I know this stuff inside-out, so just do what I tell you to do’ approach can work for some.

But for many other advisers and clients, informed consent, with a clearly documented audit trail, is far more desirable. A good risk profiler allows an investor to get a better understanding of their own risk profile.

From that strong foundation, an adviser can have a meaningful conversation around the portfolio construction they know their client will be able to live with in good times and bad. While markets are rising, a patriarchal approach is fine.

However, when markets dive, I would argue that approach will lead to more difficult conversations, that will inevitably start with the accusation “You told me to do this…”