Is the industry standard approach to risk now defunct?

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Is the industry standard approach to risk now defunct?
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I have often pondered the attempted shoehorning of risk profiles by our industry, and whether this may actually be causing a detriment to client outcomes.

From the early days of my financial planning exams, right through to naming conventions for portfolios and market commentary, there seems to be this wide acceptance that asset classes are rigidly self-defining.

Some areas of our profession (vulnerability, environmental, social and governance preferences, goal setting, objectives appraisal and cash flow modelling) are, and quite rightly, left to be explored through the qualitative and pragmatic relationship between adviser and client.

You are not necessarily vulnerable just because you are a certain age. I know people in their 40s who most certainly are vulnerable, be that through serious illness or delicate personal circumstances. I also know people in their 70s who have more technical and financial capabilities than many of their younger peers.

Why aren’t industry standards as pragmatic about asset classes and portfolio compositions as we are about other areas of personal financial planning?

Of course, this is why determining vulnerability is a unique and fluid process that only those involved can truly agree with through an open, honest and collaborative discussion.

The same goes for the morality of clients and how they like to invest their money. What satisfies the moral fibre of one individual may be vastly different to what satisfies another individual, or fund manager for that matter. How you treat a situation is wildly subjective and very personal.

What has baffled me for many years (and the current dynamics of the financial markets have fuelled my bafflement even further), is why aren’t industry standards as pragmatic about asset classes and portfolio compositions as we are about other areas of personal financial planning?

Don’t get me wrong, as advisers we have a duty of care to educate our clients on asset structures, how they behave over time, and the differences between volatility and risk. This helps clients have a deeper understanding of what risk really is and what they can expect an investment journey to look like.

Naming conventions 

This part of the process is indeed subjective, pragmatic and collaborative. Where the industry makes this process harder is through naming conventions, regulatory descriptions and pre-determining risk through asset allocation that takes no account for an individual’s personal preferences or timelines.

Take the bond market as an example. The state of the bond market has been pondered for many years due to the unsustainable yield/price relationship. Now we have high levels of inflation to deal with, hawkish central bank policy, and a Federal Reserve that is actively reducing its balance sheet, we are seeing the bond market in a state of wild uncertainty and instability.

While we know with respect to liquidation and insolvency bonds come higher up the pecking order, but what I keep asking myself is, in a diversified global portfolio, what is the bigger risk, insolvency at a company level or the biggest asset reduction on record that has the ability to determine the fate of an entire asset class globally?

Yet we still continue to refer to bonds as ‘cautious’ or ‘careful’ and equities ‘adventurous’, ‘risky’ or ‘dynamic’, or whatever synonym the industry coughs up to put one particular asset class inside a box of which there is no escape.

We are making the educative relationship with clients a little more difficult than necessary.

These descriptive words, more often than not, indicate to what extent bonds or equities take up an investment portfolio. It does not account for a 20-year investment horizon and the impacts of inflation, relative to these asset classes, ie a risk.

It does not account for the sustainability of income throughout retirement, and how various asset classes impact this, ie a risk. Is this adding value or assisting good client outcomes?

Much of this, in my opinion, is hinged on volatility. Equities tend to fluctuate in value more significantly and shareholders are the last to be paid in insolvency, but is that greater than the risk of central bank monetary policy and long-term inflation risk?

Does a more volatile daily price change really make it riskier when we look at the long-term benefits of investing and wealth creation? Surely what is ‘risky’ or ‘careful’ is just as subjective as whether or not a fund management philosophy is ‘ethical’?

By pre-determining these factors, we are making the educative relationship with clients a little more difficult than necessary.

Adam Cockerham is a director and chartered financial planner at William Dixon and Associates