Industry Voice: The need to take risk

clock • 3 min read

The concept of a recommendation forms the cornerstone of the regulatory framework. Advice is a regulated activity. There is no backstop, where an adviser may be released from responsibility for the consequences of a recommendation. These go to the grave! In any challenge, the question will come back to suitability, so it's never been more important to provide a reliable forecast in the form of an illustration to establish the need to take risk.

Advice (and now compliance) is only as good as the illustration

Most compliance activity is focused on disclosure but, before disclosure, you must create an illustration of the investment journey. Before MiFID II and RDR, a provider illustration was fine but, as recommendations need to be framed more in the context of a client's life goals and aspirations, better tools to illustrate financial planning journey are now required.

Whereas simple illustrations from a provider with low, medium and higher growth assumptions, say 3%, 5% and 7%, were sufficient in the past, this doesn't meet current requirements for suitability and informed consent. You must model the effects of risk, costs, inflation around clients' specific circumstances.

You must establish some concept of a goal, to provide context to any growth, against which the success of a plan can be judged. The best way of illustrating the path to these goals is using probability-based forecasts, in which the full range of viable outcomes, not just average case, can be presented.

Stochastic projections as the basis of investment forecasting

Over the last few years professional advisers have started to borrow more from institutional investment risk management and using stochastic-driven tools, capable of providing a forward-looking projection. 

Using a probability-based model to describe a range of viable outcomes enables the adviser to control the conversation and explain the investment journey ahead. This is critical to ensuring that a client stays confident of the investment outcome, even when they experience losses, and is likely to stay invested.

The adviser conducts the conversation in the context of the client's circumstances and goals: for example, how much money do I need for retirement? How much income can I afford to take in retirement? How should I invest to meet my children's school and university fees? How can I provide for dependents when I am gone? How can I understand the risks? Where should I be invested?

Using Moody's Analytics stochastic engine, the Economic Scenario Generator, for financial planning and compliance

The two additional components of the classic risk governance model to the client's risk profile are the ‘need to take risk' and ‘capacity for loss'. Moody's Analytics provides the market-leading stochastic modelling solution, which is unique for many reasons, not least for its reliability (confirmed in retrospect). Stochastic modelling is relatively new for advisers, but it's widely employed by a range of institutions including Royal London and Standard Life Aberdeen, and by many discretionary managers who have relied on Moody's for their portfolio optimisation and market forecasting.

The two elements that make up the Moody's Analytics model are:

    1. The rules and constraints that define the universe of viable trajectories for asset class growth and market inputs that make up the model;
      1. The simulation that is regularly run using the model assumptions - a mathematical technique that involves an element of random generation to create thousands of scenarios from which probabilities of all outcomes can be ascertained.

In this way, a deterministic view of limited possible outcomes is replaced by a universe of possible outcomes from which clients can make better-informed decisions.

This article is an extract from Synaptic's new, free, downloadable guide on how to build an investment strategy around the A2Risk Attitude to Risk Questionnaire and the Moody's Analytics risk framework.  

Click here to download the full guide

Advisers can access this market-leading investment strategy via Synaptic's new tool, Pathways Risk Explorer. Click here to find out more.

 

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