The perils of risk drift

The implication of the word ‘risk’ is that things can go wrong.

Risk management, therefore, is exercising skill and art to reduce the chances of things going wrong.

In the advised world there are three parties involved: the client, the adviser and the investment manager.

In the majority of cases the adviser is the intermediary, looking after the interests of the client, who has the responsibility of ensuring that all aspects of the risk conundrum are aligned, remain aligned and are working in the best interests of the client.

I remember sitting in a darkened room at the Treasury, almost 20 years ago, helping with one enquiry or another. The subject of risk came up and, in particular, what standard risk indicators could be used.

The regulators, although still keeping a close eye on suitability of recommendations, are much more comfortable with advisers' current approach to suitability and measurements of risk.

The lady leading the discussion for the Treasury visibly paled and rather aggressively suggested that the majority of the industry, including the regulators, did not understand risk and it was definitely an area that "should not be explored further at this time".

I think the industry has come a long way since then, to the point where risk is now becoming the primary measure that influences investment selection, as it is one of only a few quantifiable measures of suitability. Of course, acceptable performance is still important and should be looked at in relation to the amount of risk taken.

However, the industry has needed a lot of guidance over the years and I recalled the words of the lady at the Treasury as the Financial Services Authority (now the Financial Conduct Authority, or FCA) published a final guidance paper (fg 11-05) in March 2011 indicating that nine out of 11 client risk profiling tools were flawed.

Further, those that did not use these tools, preferring the traditional ‘know your client’ approach exhibited similar weaknesses.

The flaws in the process could have meant unsuitable advice, and unsuitable advice may mean less chance of a client achieving their goals.

Measuring risk

Since then, lessons have been learnt, tools have been modified and knowledge accumulated. The regulators, although still keeping a close eye on suitability of recommendations, are much more comfortable with advisers' current approach to suitability and measurements of risk.

It is not too difficult to see that there is a direct correlation between taking the right amount of risk, making suitable recommendations and the client achieving favorable outcomes.