Rob Fisher, sales director at FundsNetwork, says in order to ensure clients stay the course advisers need to concentrate on risk profiling
Which is more important, investment selection and portfolio design, or managing clients' expectations of risk and return? Both are key, but the latter is vital to ensure clients 'stay the course' long enough to realise the benefits of their adviser's portfolio recommendations. Indeed, it is our view that more investment value is destroyed by investors failing to stick with 'right' choices than by making 'poor' investment selections.
And the chief reason that investors abandon their plans by surrendering policies, going into cash or ceasing contributions is because they experience investment volatility beyond their psychological tolerance. On this basis, we would argue that building the right investor understanding of risk is the most important driver of long-term client success.
Good advisers have long recognised this, but the advent of FSA suitability rules and 'know your customer' regulations have led to more formalised client risk-grading approaches. However, simple categorisations have obvious drawbacks: one man's 'medium risk' is another man's 'speculative'. In any case, the most important part of the risk assessment process isn't just assigning of a risk profile or score, but the conversation which helps clients understand that high risk doesn't simply mean high returns, and that there exists a complex relationship between different types of risks, likely growth rates and the impact of time.
So is the advent of more sophisticated risk-profiling methods - often part of portfolio planning tools - a helpful development? We currently hear two different schools of thought. Some advisers fear that planning tools may oversimplify the advice process or diminish the adviser's stature. But this is very much a minority view, and the large majority of advisers we have spoken to in connection with the launch of the FundsNetwork Portfolio Planner have welcomed what they see as vital 'decision support' tools.
And herein lies the distinction. If you accept that planning tools are not trying to provide advice, and are simply supporting an adviser's own process, then the opportunity becomes clear. But the onus is on tools-designers to provide sufficient configurability and flexibility to reflect adviser processes and preferences, rather than imposing a one-size-fits-all methodology. This is certainly the goal of the 'next generation' of planning tools destined for the IFA market, of which our own is an example. Given the flexibility now on offer, it's not surprising that in a recent FundsNetwork survey, we found over 80% of advisers claimed to already use planning tools, with the majority of the remainder anticipating adoption within the next 12 months. This must mark one of the fastest-growing areas of practice development.
Where tools offer a risk-profiling solution, and not all do, there are three main approaches in use:
• A self-determining approach, where a client is given a series of 'descriptions' to choose from, or a simple 1-10 rating.
• A different approach that has a hardcore of enthusiastic supporters is the psychometric method. Such tests ask clients to agree or disagree with a series of statements mostly unrelated to finance. This predicts a 'personality type' including attributes such as risk-taking and coping with negative outcomes. While comprehensive, we've heard advisers comment that some psychometric tests have too many questions and take overly long to complete.
• Behavioural profiles are similar to psychometric tests and use a series of questions which clients agree or disagree with, but these are usually finance-related. As with psychometric tests, questions may be posed in subtly different ways in order to overcome the issue that clients may not always say what they mean, or mean what they say. Behavioural approaches can appear more relevant to clients, require fewer questions, and may work better in the adviser 'real world'.
For an adviser to decide which approach fits their business, it's worth asking why they are undertaking this. If it's to help clients gain insight into their own financial beliefs and attitudes, then a self-determining route is unlikely to support this. If they are also keen to respond to the growing litigation culture and demonstrate to regulators and PI insurers that their firm has a systematic approach to client 'suitability', then ticking a box from 1-10 may not be sufficient.
Whichever risk-assessment method is used, the next step is to assess how a client's risk profile reconciles with their assets, goals and time-horizon. In order to determine an appropriate asset allocation strategy. This is where the combination of a risk-profiler and a stochastic modelling tool offers powerful advantages.
Typically, a stochastic model contains a database of past returns from a range of asset classes, and also makes forward assumptions on factors that impact returns - chiefly inflation and the equity risk premium. By performing thousands of calculations, a stochastic tool will examine a range of possible outcomes for a given set of client-specific inputs and indicate how statistically likely each outcome is.
Because assumptions on timescales, funding rates and risk-levels can be varied to give a changed asset allocation strategy and different forecast returns, this can facilitate a very high level of shared understanding between the client and the adviser. Critically, it helps advisers and clients explore the difference between 'risk appetite' (in simple terms, a client's psychological tolerance to changes in investment values) and 'risk capacity' (which will also take into account the different degrees of 'hardship' in failing to meet goals) to gain a much more profound shared understanding of risk.
Lastly, and most importantly in these liability-aware times, the planning tool will provide for advisers a robust audit trail of client responses which demonstrates a clear link between risk assessment and asset allocation strategy. With the emphasis on asset allocation-based advice in the Sandler report, don't be surprised if this rises up the regulatory agenda in coming years. Forward-thinking advisers will already know the solution.
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