Graham Bentley offers his opinion around risk assessment and solutions matching.“I am not a number…” Number 6, The Prisoner
The FCA’s Rory Percival recently introduced a new ‘offence’ to the pantheon of suitability misdemeanours – retrofitting - where the adviser goes through an advice process geared to provide the solution he or she wants to use, or is already using. Rather than selecting solutions from the wider market in response to a client need, solutions are pre-ordained via an existing Centralised Investment Proposition (CIP) consisting of a range of risk-focused funds and model portfolios. This is in turn encourages ‘shoehorning’ clients into those solutions. The key signpost on this investment shortcut is the Risk score. A number intended to represent a client’s willingness to take on risk is also ascribed to a portfolio asset allocation as a reflection of its anticipated price behaviour. Such a process is predicated on an assumption that there is a common risk measure that applies to both people (clients) and numbers (prices). However, a discussion (what we used to do before we got profilers) about risk has to draw out an investor’s need, and ability to take on risk. This creates an altogether more complex construct. Prepared solutions may require a little more work.
To illustrate risk as perceived by people, imagine a game where I offer you three playing cards – two red Aces and an Ace of Spades – face down. The odds on you drawing a red card are 2-1 on, and the minimum bet is £1. If you draw a red card, you win 50p plus your £1 – draw black and you lose your stake. Most people would be happy to play, with little debate. If I subsequently shuffle the cards and ask you to play again, you might be less happy to play if the minimum bet is your house. The probability of winning hasn’t changed –but it feels different doesn’t it? This demonstrates a critical point – risk is meaningless without a consequence. Consequences relate to an investor’s need to take on risk. A client saving for retirement needs to be asked what they intend to do in retirement that requires surplus money? How would they feel if there wasn’t enough money to do “X”? If the client shrugs, then the goal isn’t worth taking risks over and shouldn’t be funded for – it has little consequence. Don’t take risks when you don’t need to.
Think about risk mitigation in the same way you might about insurance. My house is over 500 years old. It has never burned down. I have a long record of ‘past performance’ to go on. However, that does not deter me from purchasing fire insurance. However improbable the event, its impact would be catastrophic – the house is irreplaceable. On the other hand, the UK climate suggests on any given day there is a good chance of me being caught in the rain. But its consequences are trivial, so I do not insure against that. However, if I was producing a village fête where hundreds of people were due to attend, and that had cost a great deal to organise, then the consequences are greater and I may wish to insure. In order to assess that need, I have to account for both probability of a ‘bad thing’ happening, and its impact on me if it does happen. Consequently, I can define risk in the client’s terms, rather than via a volatility measure that relates to numbers, not people.
Risk = Probability multiplied by impact.
This allows high probability events with low impact to be ignored, but low probability, high impact events to receive attention.
“Matching client risk to investment risk probably requires a rather more sophisticated process than Bingo-like number matching.”
So let’s reconsider the risk profiling process. In varying scenarios how would the client feel if a certain event took place? What if their goals were not achieved? Have they thought through the impact of the negative event? Be careful of your own biases here; your attitude to risk also involves business and regulatory risk – avoid subliminally imposing your attitudes on your client. Matching client risk to investment risk probably requires a rather more sophisticated process than Bingo-like number matching. We too easily confuse risk and uncertainty. Risk implies probability – in the two dice game Craps I can calculate the odds of throwing a 7 (5-1), and I take an informed choice. Investment isn’t like that – here uncertainty rules. With Risk, we don’t know what is going to happen next, but we do know what the probability distribution looks like. As for uncertainty, we don’t know what is going to happen next, but furthermore we don’t know what the possible distribution looks like either. Stock markets are unpredictable, but not capricious or random. This is what keeps us interested. There are certain things we believe to be true, e.g. fixed Income prices are less variable than equity prices. However unlike the laws of physics these behaviours are not predictable and successful outcomes are not necessarily repeatable.
Risk assessment and solutions matching is not a simple process. However, if you do want an easy shorthand…“Expect the best, plan for the worst”.