Risk-profiling tools are imperfect models which threaten to turn the art of investing into an imprecise science and should only be used as a guideline, says Ian Lowes.
The MD of Lowes Financial Management was speaking after the FSA today warned over-reliance on risk-profiling and asset allocation tools can lead to customer detriment and flawed outputs.
Lowes (pictured) thinks the FSA is right to raise concerns about investment selection failures and says advisers using risk-profiling tools merely as part of a "tick box" process need to "open their eyes" if they think such an approach makes for a successful investment strategy.
"Investment advice is an art and not a science and recently there has been a push towards using tools which try and turn that art into a science," he says. "We are yet to find a risk-profiling tool we think is good enough."
Lowes adds for inexperienced advisers, lacking an understanding of the mechanics of risk and how it can transpire into loss, then asset allocation and risk-profiling tools provide a starting point. But such tools are based on a model or formula which is not necessarily correct and caution should be exercised when using them.
Highlighting their limitations, Lowes - also founder of Structuredproductreview.com - says risk profiling tools tend to pigeon-hole investments into various categories and are therefore of little use in the structured products market where classifying investments is fraught with difficulty.
In today's guidance paper, the FSA highlighted recent miss-selling cases of Lehman-backed structured investment products "where firms sold investments in high concentrations because they misunderstood the associated and underlying risks".
The FSA also raised concerns firms are using volatility as a sole risk measure on model portfolios - a process Lowes says is flawed.
"You cannot use volatility alone to assess risk," he says. "For example, a fund which loses 10% per annum is considered low risk if we use the volatility measure as a guide because it moves in a straight downward line."
He adds some advisers are increasingly turning to risk-profiling tools in an effort to comply with regulatory requirements without really understanding their limitations.
"A lot of advisers want to tick boxes and satisfy the regulator and are therefore going through this risk-profiling process," he says.
Lowes says it is essential clients understand the shortcomings of these tools.
"They cannot predict the future - they are only a model and the adviser has to ensure the client understands this," he says. "It is all about making sure the client knows the adviser does not know what the market will do. Some risk-profiling tools can help but they are not a get out of jail free card."
Lowes says the key to assessing risk is talking to clients.
"The clients' attitude to risk will change with circumstances around them. It is all about maintaining a personal relationship with clients and speaking to them on a regular basis."
Industry compensation scheme refuses to cover it
No-deal Brexit will cause 'a tremendous shock on the UK economy'
‘If our people are the best they can be, then so is our service’
Asset managers must make changes
Follows exit of Hamish Purdey