Chris Gilchrist explains why his firm uses an ‘investment suitability’ approach with clients rather than the traditional risk assessment process.
I’ve always been sceptical about assessing investors’ attitudes, whether to risk or anything else. Perhaps attitude to financial risk is a stable personality feature, as the psychometric guys claim. But what’s the relevance of this? Of far greater importance is what any experienced adviser knows: people’s tolerance of risk changes with experience. What this means is that early in their investment journey, people are more likely to panic and sell - with the potential for a claim against the adviser, regardless of what he told them at the outset.
Tolerance of risk changes. And so does capacity for loss, since this is heavily circumstantial. At FiveWays we used to use a ‘capacity for loss’ checklist, focusing on analyses familiar to financial planners: what proportion of income will be derived from the investment, how secure is retirement income, what are expectations, how good is health, how secure is employment, etc.
In writing ‘The process of financial planning’ as part of the Taxbriefs Advantage series, my co-author Danby Bloch and I agreed that capacity for risk should outweigh other factors in determining the kind of investment solutions proposed by an adviser. I haven’t yet met a serious adviser who has contested this judgment. Note that we talk about capacity for risk, which is slightly wider than capacity for loss in that it includes potential shortfalls from retirement income and other goals as well as outright losses. Look at FOS judgments and you will find that most advisers lose cases on capacity issues.
There are good regulatory reasons why capacity should be advisers’ main focus. But there is also the business and marketing case. Anyone can find an online ATR questionnaire and do that themselves - they don’t need an adviser for that. But only the adviser can assess capacity - it is something that most clients struggle to do for themselves. So capacity assessment is where the adviser really delivers value to the client, and advisers are missing a trick if they don’t explain and emphasise this.
We now use an ‘investment suitability’ rather than risk assessment process, with a heavy emphasis on capacity. We were fortunate to come across Harbour, and have worked with its creator David Roberts to adapt it to use by advisers. Though Harbour’s 20 questions include several on capacity, the system also includes an override function where the adviser can use a menu of additional circumstantial constraints to alter the indicative profile allocated from the questionnaire scoring. We find that the override is used in about one in ten cases, usually to lower the risk profile we recommend.
Because all the Harbour data is accessible via its MI functions - and all the data generated by a firm is its property - adviser firm proprietors like me can keep a close eye on individual advisers’ profile allocations to ensure that we have consistency across the firm. That consistency - do Mrs Jones and Mrs Brown, with almost identical circumstances and needs, get the same recommendations from advisers A and B? - is, of course, what most adviser firms struggle with. We now feel completely confident in the consistency of approach by our seven advisers.
I am sure that simplified ATR questionnaires, perhaps with a nod to capacity, will form the front end of most robo-advice engines. It’s extraordinarily difficult to design a fully automated capacity assessment engine - the range of circumstances, and the interaction between them, that can cause an adviser to say ‘You can’t afford that level of risk’ is beyond current algorithmic capabilities. That is great news for professional advisers, who ought to make assessing capacity for risk a central part of their advice process.