This article was first published in the first-quarter 2016 edition of Personal Finance magazine.
Mismanaged investment risk is a common cause of abrupt, unhappy endings to relationships between consumers and their financial advisers. So says Geoff Davey, who has spent many years refining a tool that enables advisers to gauge accurately just how much investment risk their clients can and should bear.
Davey is the co-founder and a director of FinaMetrica, an Australian company that has been designing risk-profile tools for advisory companies around the world since 1998.
Even if you do not use an adviser, failure to assess key investment risks accurately could result in disappointment with your choice of investments.
The general code of conduct, which forms part of the Financial Advisory and Intermediary Services (FAIS) Act, obliges financial advisers to advise you on financial products that are appropriate to your risk profile and needs. In many of her determinations, the Ombud for Financial Services Providers (or FAIS Ombud) has found in favour of consumers, because their advisers recommended investments, such as property syndications, that were unsuitable.
Many advisers use risk-profiling questionnaires to test your attitude to risk before they recommend an investment. These questionnaires typically ask how you would feel if your investments lost money, the returns you expect to earn, and whether you would describe yourself as an aggressive, a moderate or a conservative investor.
In 2012, Noluntu Bam, the FAIS Ombud, noted that she frequently encountered a disconnection between a complainant’s tolerance for risk, as assessed by his or her answers to a risk-profile questionnaire, and the complainant’s financial circumstances and actual ability to withstand losses (capacity for risk).
Bam went on to say that the answers to risk-profile questionnaires can be interpreted in several ways, and they are not always specific or relevant to the investment at hand. Risk must be disclosed in “clear, unambiguous language”, she said.
A survey of risk-profile questionnaires conducted by the Financial Services Authority (FSA) in the United Kingdom (now the Financial Conduct Authority), reported in 2011, found that:
* Most advisers divided the investment risk spectrum into different categories, but their descriptions of the categories were vague and did not effectively explain or differentiate the various levels of risk.
* Where risk-profile questionnaires correctly assessed a consumer’s risk profile, the selected pro-duct or portfolio, as well as the underlying asset allocation, did not always match the risk profile.
* Advisers did not focus sufficiently on how much risk you, as a consumer, were willing to take, and did not take into account your needs, goals and circumstances. For example, they failed to consider whether you would be better off using a lump sum to repay debt rather than investing it, or they chose an investment that you could not liquidate at short notice, even though your circumstances were such that you might need to access your capital in the short term.
* Many advisory firms failed to understand the nature and risks of the products or assets selected on behalf of consumers.
* Although most advisory firms considered their clients’ attitude to risk when assessing the suitability of products, many failed to take account of their clients’ capacity for risk.
* Many firms did not understand the risk-profile questionnaires they used.
The FSA analysed 366 cases reported to it between 2008 and 2010 in which the financial products recommended by advisers were found to be unsuitable. It concluded that, in 199 cases, the problem was that the investment did not meet the consumer’s “attitude to risk”.
The Financial Conduct Authority is leading the way with guidelines on how advisers in the UK should determine the risk that consumers should take. Unfortunately, in South Africa, numerous measures to raise the level of professionalism in financial advice and to ensure you are treated fairly have failed to spell out what advisers should do when determining your risk profile or “attitude to risk”.
FinaMetrica has developed a web-based questionnaire, in conjunction with the Applied Psychology Unit at the University of New South Wales, to ensure that questions and answers about risk tolerance are valid and reliable. Many South African advisers use this questionnaire.
Davey and the two organisations representing financial planners in South Africa, the Financial Planning Institute (FPI) and the Financial Intermediaries Association of Southern Africa (FIA), believe more should be done to determine which products are suitable for you, based on your risk profile.
Establishing best practice
In 2014, a working group consisting of Davey and representatives of the FPI and FIA, led by Anton Swanepoel, the managing director of Amity Wealth, who has served both the FPI and FIA, produced a paper titled “Assessing suitability with regard to investment advice”. Its aims included establishing industry best practice for “suitable” financial advice, to avoid the need for regulation. The paper was sent to industry bodies, such as the Association for Savings and Investment South Africa, which represents most unit trust companies and life assurance companies, and to National Treasury and the Financial Services Board (FSB).
Since then the FPI and FIA have collected comments and conducted national surveys among advisers on behalf of the working group. The aim is to release the second edition of the paper towards the middle of this year.
The paper provides some insights into how you or your adviser should determine your attitude to risk. It highlights that it is in your best interests to know about, and to participate in, a proper risk assessment, and it goes on to say that your adviser should:
* Define your investment needs and objectives;
* Define and quantify the investment risks you need to take to meet your financial needs and goals (your required risk);
* Define and quantify the risks you can afford to take to meet your needs and goals (risk capacity);
* Define and quantify the risks you are willing to take to meet your needs and goals (risk tolerance);
* Provide you with appropriate information about the risk profile of investments; and
* Provide you with suitable advice and take reasonable steps to ensure that you understand the advice and can make an informed decision.
The practicalities of implementing these steps have been the subject of much debate in the financial ser-vices industry, and the paper makes some proposals on how your risk profile should be determined, so that your adviser can advise you appropriately.
The paper also highlights the problems that arise when the financial services industry uses inconsistent and, at times, even misleading descriptions of risk. One example is labelling unit trust funds that have up to 40-percent exposure to risky assets, such as equities, as “cautious”. It suggests ways in which the industry can develop sound and consistent interpretations of risk and risk-profiling.
Here are some of the key issues that arose from the working group’s paper:
1. Risk definitions should be standardised
The working group says stakeholders in the financial services industry define risk in different ways. Fund managers, for example, define risk as “volatility around an average” and measure volatility in terms of standard deviation. However, the working group says some leading fund managers have started to change their definition of risk to “permanent loss of capital”.
Financial advisers, on the other hand, refer to risk as “loss of capital”, but they also define it as “an investment return that does not match or out-perform inflation over the investment term”, the working group says. Consumers refer to risk as “loss of capital” or “loss of investment value”, which, the paper notes, is how the FAIS Ombud interprets risk.
2. Risk should be defined from the consumer’s perspective
The group suggests that all stakeholders should adopt a common definition of risk that has consumer protection at the centre, because the consumer is the end client. This definition should be consistent with the ordinary meaning of the word “risk”, should be aligned with the FAIS Act’s objective of protecting consumers, and should be consistent with the outcomes of the Treating Customers Fairly principals.
3. Risk is temporary or permanent
The working group proposes that risk be defined as the “the temporary or permanent loss, or decrease, of a client’s investment value”. This definition would cover the losses experienced by many of the consumers who invested in property syndications.
The schemes and the advisers who promoted them argue that investors have not lost their capital; instead, they claim, investors simply do not have access to it. However, for consumers, this is an investment risk that has been realised.
This issue was highlighted by the first of two FAIS Ombud cases against R & S Walsh Investment Consultants of Port Elizabeth and its representatives, Ronald Walsh and Guy Coleman.
In 2012, Bam found the advisory business and Walsh and Coleman liable for the decline in the values of a 69-year-old pensioner’s investment plan and living annuity. The pair had switched the pensioner from conservative investments to far more risky ones, which resulted in his investment values being almost R500 000 less than they would have been if he had remained in his original investments.
Bam found that, although the pensioner had filled in a risk-profile questionnaire that reflected he was a “moderately aggressive” investor, the pensioner’s investments were switched into aggressive investments. The firm and the advisers could not explain the contradiction between the pensioner’s stated requirement that he needed to have access to his funds “all the time”, which indicated that a conservative investment would be most suitable, and his supposed willingness to tolerate fluctuations in the market, as indicated by the risk-profile questionnaire.
Last year, Bam again found Walsh and Coleman and their business liable for the losses experienced by a retired Port Elizabeth couple. In 2007, before the global financial crisis, the couple invested in what were described as “mostly moderate” investments. After the crisis, Walsh and Coleman switched them into higher-risk investments, including very high-risk resources funds.
The couple complained to Bam in 2009 that their investments had lost more than 50 percent of their value, and they had stopped drawing an income from their investments and instead relied on other savings, according to the ombud’s ruling.
The couple said they had been advised to place their funds in high-risk investments with the promise of a better return, but the risk implications were never explained to them. According to Bam, they said they would never have invested in such aggressive funds if they had understood the volatility to which they were exposed.
Bam held Walsh and Coleman and their business liable for a loss of investment value of R200 000.
4. Your risk profile should be clearly defined
The working group says the FAIS Ombud’s determinations focus primarily on complainants’ risk tolerance, but other types of risk should be taken into account, namely your “required risk” and your “risk capacity”. The working group suggests that your risk profile should include your risk tolerance, your risk capacity and your risk requirements or financial needs. It suggests that the following definitions are adopted:
* Your “risk profile” is the appropriate level of risk with regard to the risk required, your capacity for risk and your risk tolerance.
* The “risk required”, the group says, is the risk you need to take to meet your goals, given the money you have to invest.
* The “risk capacity”, or your capacity to withstand loss, is your ability to sustain worse-than-anticipated outcomes without severely compromising your goals.
* “Risk tolerance” is your general willingness to take financial risk, but it is also a psychological trait.
The group’s paper notes that your investment term is vital in defining your financial needs and plays a crucial role in determining your risk profile.
None of the risk components can be properly quantified without taking the investment term into consideration, it says. This, rather than your age, should be the primary consideration in determining your needs and risk profile.
The working group says it is vital that you understand your financial needs and goals, the risk you need to take to achieve those goals, and whether you can afford that risk and are prepared to tolerate it.
Asking the right questions to determine your risk tolerance and risk capacity is both an art and a science, Davey says. Finding your risk profile involves making separate assessments of the risk you need to take, your capacity for risk and your risk tolerance, and then comparing these assessments to see if there are any mismatches. Mismatches need to be resolved, and the outcome will be the optimal solution for you, given your often-conflicting needs, Davey says.
Risk-profiling has evolved since the mid-1980s, when it involved a mix of goals, time horizons, risk tolerance and investment experience. In the late 1990s, psychometric risk-tolerance testing was introduced. In the early to mid-2000s, risk capacity was introduced as a separate constraint.
5. The risk of the investment should be clearly defined
The working group says the risk profile of an investment should be defined as it is in the Oxford dictionary: “an analysis of a possible investment that considers how likely it is to result in loss”.
The group says investment managers need to align the risk profiles of their funds with the definition of risk as understood by investors. “If investment managers are willing to adopt this approach, it would go a long way in assisting the industry in solving some of the problems recorded in this paper,” it says.
The FSB published a notice in 2014 that obliges collective investment schemes, which include unit trust funds and a number of exchange traded funds, to publish warnings of the risks associated with investing in a fund. As a result, many unit trust funds and ETFs have started publishing their maximum drawdowns, which are the largest falls (from peak to lowest point) in the value of a fund over specific periods of time, typically expressed as a negative percentage return.
The FSB is working on templates for key information documents that financial institutions will be expected to produce for each of their products. Key information will include the level of risk associated with an investment. The working group adds that risk should be quantifiable – in other words, it needs to be made clear by how much an investment could depreciate in value over a specific period.
The group says advisers cannot help investors to make informed decisions, or manage their expectations, when risk cannot be quantified and measured.
The working group proposes that risk is disclosed as the possibility of losing “x percent” over a specific investment period.
Quantifying risk is the most important thing that industry stakeholders should agree on to address the problems highlighted by the FAIS Ombud, the working group says.
6. You should understand risk and return
Risk and return go hand in hand, and you should make an informed choice about the trade-off between the two, the working group says. The risk/return trade-off must be realistic and attainable.
Sometimes, it says, fund managers are instrumental in creating unrealistic expectations in the minds of advisers and clients – for example, when a fund targets a return of inflation plus six percent without any losses over any rolling 12-month period.
Your risk/return expectations must be agreed on with your adviser and recorded. If, after that, there is a mismatch between your expectations and your risk tolerance, that is not your adviser’s problem. You have to choose what you can live with, and your adviser must clearly record your choice.
For example, if you expect a return of inflation plus five percent a year over a five-year rolling period, but you are not willing to accept a decrease of 15 percent in the value of your investment over any 12-month period, you have to lower your expectations. Your adviser must record that you have chosen a lower return, because you are not prepared to accept the risk that comes with the higher reward.
Robo-advice
Financial advisers and companies are increasingly offering robo-advice, which is based on your answers to questionnaires and algorithms. Robo-advisers rely heavily on simple risk-profile questionnaires and model portfolios to which your risk profile is matched.
Paul Resnik, the co-founder and a director of FinaMetrica, and Gerda van der Linde, a director of the Behavioural Finance Institute, says a typical robo-adviser recommends portfolios based on an algorithm scored on three factors: your risk tolerance, your capacity for loss and your investment time horizon.
In an article titled “The impact of robo-advisers will be widespread, here’s what you need to do”, Resnik and Van der Linde say this kind of profiling exercise does not take account of your existing assets, tax position, the consequences of financial changes, estate planning, social security, differences in your risk tolerance, or differences between the risk tolerances of the two people who make up a couple.
“Nor do robos necessarily taken into account investor anxieties when markets run or crash, apart from warning the adviser to increase the regularity and personalisation of communication. Robos aren’t very likely to hold clients’ hands in times of stress. Because they don’t have a detailed understanding of the investors’ goals, and have great difficulty framing investment experiences against investors’ goals, robos have been described as ‘fairweather advisers’.”
The appeal of robo-advice is that it is cheaper than personalised advice, but if you want a customised financial plan and individual attention, you will have to pay more for advice that takes all the aspects of risk into account.