The risks of risk profiling
One of the most persistent myths of financial planning is the belief that a client’s approach to investment risk determines the investment strategy they need.
In practice, one of the first steps undertaken by many investment advisers is to determine their client’s attitude to risk, volatility and capital loss – their “situational and psychological risk tolerance”. In fact, many advisers rely on this assessment to determine both the investment strategy most appropriate for the client and the products best suited to their preferences.
Unfortunately, this approach is fundamentally flawed and misrepresents an adviser’s legal and professional duties.
The historic practice of using risk profiling to determine strategies and select appropriate investment portfolios – without any real consideration of the client’s other objectives, needs and circumstances – is not only bad advice but contrary to the letter and intent of the law.
Profiling and professional obligations
In financial planning, risk profiling is generally used to construct (or select) an appropriately diversified portfolio likely to achieve the clients’ goals without exposing them to risks (volatility, variability and capital loss) with which they would not be comfortable.
'Risk profiling' is a useful exercise, but it's important to appreciate that an adviser has no explicit statutory obligation to “risk profile” a client in order to provide suitable and appropriate advice. While assessing situational and psychological risk tolerance is important, it is not, and should not be, the primary determinant of an adviser’s recommendation.
Even ASIC only consider a client’s attitude to investment risk as one of many factors that comprise the client’s relevant personal circumstances.
The purpose of profiling
If a client’s attitude to risk is only one of their “relevant personal circumstances”, then logically, it is not, and should not be, the only factor that determines the recommendation. If we start by acknowledging that the client's needs are the primary considerations around which the recommendation should be constructed, their 'investment preferences' are properly relegated to being secondary considerations. They'll influence the direction of the strategy but they do not determine it. Industrialised advice models might be built on the alternative proposition, but personal advice - suitable and appropriate advice - is needs and goals driven.
In our view, it's vitally important for advisers to understand that 'Risk profiling' isn't the solution to a client's needs but simply a mechanism for initiating
FOS' focus on 'gaps' and 'trade-offs' acknowledges, for example, that a client with a conservative investment preference may not be able to achieve their lifestyle and objectives with a conservative investment strategy. Good advice identifies these competing needs and helps the client to reconcile the divergent objectives – either by assuming a more aggressive approach to achieve their goals or by helping them scale back their goals to those achievable through a conservative approach.
In any event, the specific identified risks, their effect and relevant consequences and implications need to be clearly explained. They must also be considered, and explained, in the proper context and with sufficient reference to the client’s sophistication and experience. Licensees and advisers may be improving their approach but we've seen far too many recommendations created to suit the client's identified risk profile rather than the client's identified needs. This has to change.
Filtering financial preferences, subjective experiences and personal objectives through a simple methodology, without applying your own professional judgment to the results generated, generates unsuitable advice. This is the real problem with using risk profiling to substitute for, rather than to complement, an effective discovery process.
Assessing 'real' risks
As compliance experts, we understand that a client’s investment preferences, capabilities and needs are used for a variety of purposes including strategy development, asset allocation, portfolio construction and product selection. We know that appropriate investment advice is built on the foundation of the adviser's solid understanding of their client's appetite for, and tolerance of, investment risk. We accept that informed consent requires the client to understand, and accept, the risks involved in implementing the recommended strategy.
We understand that the industry is working hard to reconcile professional obligations and commercial needs but we are concerned that the retail advice industry has spent too much time and effort on classifying and disclosing generic risks, and not enough on addressing the “real” risks with which most consumers are concerned. We believe that consumers care less about out-performance and the technical aspects of currency, market and operational risks and more about the real likelihood of full or partial capital loss. Too often, advice that we're asked to review, fails to clearly (or effectively) address the likelihood, and impact, of capital loss.
This is not a disclosure issue. Neither is it a compliance issue. It's a professional challenge for an industry wedded to boilerplate templates and advice systems. If advisers and licensees want to successfully avoid client complaints, they need to more effectively communicate to their clients that every investment – from a term deposit to an international hedge fund – involves a risk that
some or all the capital might be lost,
that the returns may be inconsistent from time to time or that
the value of the investment might vary greatly over the period of investment.
To those that assert that this is currently done, we answer that while it may be done by some, it's not done by all and it's generally not done well. In our view, burying real risks in a static, bloated and impenetrable advice document doesn't address the substance of an adviser's professional duty. Advisers should embrace both empathy and engagement and remember that their duty to consider, communicate and manage “investment risk” is an ongoing responsibility; it requires them to regularly consider their client's investment preferences and the relevant product and market risks.
Disclosing product and market risks
Traditionally, advisers and licensees have sought to address “investment risk” through a belts and bracers approach to disclosure. Their advice considers currency risks, the chance that legislation may change, companies collapse and markets capitulate. The limitations of disclosure have been addressed elsewhere but the problem with this specific approach is that, rather than protecting the adviser and equipping the client to make an informed decision about the recommendation, it trivializes risks and reduces comprehension.
The practical limitations of this approach were highlighted in Evans & Ors v Brannelly & Ors  QDC 269 in which McGILL DCJ noted that:
Disclosure is not an acceptable alternative to your professional judgment. If you're struggling to reconcile these clear principles with your compliance requirements, please remember that less is more (effective).
While some risk profilers believe that a person’s preferences – both their willingness to take risks and their tolerance of volatility and variability of returns – is a static measure; our view, consistent with FOS’ determinations and behavioural psychology, is that a person’s investment preferences are fluid, contextual and experiential.
Investment preferences will move and change over time. The abiding value of an ongoing advice relationship is that the client's portfolio and exposure can be adapted to changes to their circumstances, needs and preferences.
Both intuitively and anecdotally, investors tend to be more aggressive when markets perform well and less aggressive when markets are down. When a highly geared portfolio is consistently outperforming the market, investors are generally less concerned about the portfolio’s inherent risks than they are after the market crashes. The real challenge for an adviser is to accurately assess a client’s tolerance of risk on the basis of both prospective and retrospective measures.
Regardless of the profiling tool used, it's important to appreciate that a person’s approach to investment risk is coloured by their personal experience and is, in fact, highly subjective.
Context is for Kings
Reasonable, suitable and appropriate advice should address “Investment risk” clearly and effectively. In our view it's difficult, if not impossible, to secure a client's informed consent without openly addressing capital security and the variability and volatility of returns. These conversations may be occurring but, too often, risk appetite and tolerance is assessed by reference to generic factors, such as inflation and investment horizons, rather than by reference to that client’s specific needs, circumstances and experience.
The law supports the proposition that advisers should cleave to context. In our view, the adviser’s key failure in Paige was not their risk profiling process but their manifest failure to clearly communicate what the assessment meant for the client and how it would impact portfolio construction, asset selection, their capital and their return on investment. This was, in our view, not a technical issue but a profound advice failure that provided the client with “no explanation …. of the consequences of any answer which might be obtained”.
An adviser should identify and address in their SoA the specific risks which, in their experience and based on their research, present a material risk to the client’s capital or affect the likelihood that client will achieve their goals. In our view, an adviser should focus their client's attention on the likely, proximate and relevant risks rather than disclosing each and every possible risk. For example, an adviser may be less concerned about the risk posed by the internal gearing levels for a major retail fund than about the risk posed by their new research team and methodology. In fact, the adviser may reasonably consider that neither is a relevant risk to their client. Academic research suggests that investors generally chase performance and ignore risk, but when potential risks crystallise client preferences often (retrospectively) change and the adviser is left to rationalise, defend and explain their choices.
Specificity, clarity and context are critical. As a wise man once said, "Universal law is for lackeys. Context is for kings."