Do you know your Attitude to Risk from your Capacity for Loss?

11 July 2017

Experts are warning that January 2018 will be the deadline for getting your house in order in regards to risk profiling and the ‘use of tools’, as this is the date that the MiFID II legislation comes into effect. The bible in this respect is the Finalised Guidance document of 2011: ‘Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection.’ Here the primacy of a client’s investment aims was established and the linking of objectives to risk-based strategies.

The responsibility of the adviser is to ensure that ‘the client is able financially to bear any related investment risks consistent with their investment objectives’. Moreover the adviser must ensure that the client has the ‘necessary experience and knowledge to understand the risks involved’. Here’s the punchline: the ‘route by which this key assessment is made is through the ability to assess a client’s ‘Capacity for Loss’’.

Many if not most complaints are upheld on the basis of whether a client’s risk exposure was suitable or not, based on their ‘Capacity for Loss’ (perversely in some cases, even when a client has done well). If this assessment is so important where is it falling down for so many advisers? Thematic work has highlighted the poor use of tools, the lack of proof of suitability and failure to gain ‘informed consent’ around the risk inherent in the investment strategy recommended.

Many advisers are conflating outputs from their Attitude to Risk Questionnaire with their fuller consideration of the client’s circumstances. Capacity for Loss is different to the assessment provided by the questionnaire. It is an objective evaluation of the extent of losses that can be sustained before there is ‘material impact on standard of living’.

Simply asking a client to confirm their Capacity for Loss will not work, as it is not a subjective response that is required. It requires the skill and objectivity of an adviser, who will balance what he or she knows about the client and their objectives to recommend an investment strategy within their capacity to sustain possible losses.

It also underlines why research and recommendations must be ‘personalised’. The wrong approach is to say: ‘The questionnaire says you’re balanced and you get portfolio 5.’ Evidence of this approach being used appears regularly
in the trade press. As providers of best advice tools, we get the equivalent challenge: ‘ The questionnaire says 3 and the investment I want to propose is a 4. How do I get round this?’

The answer of course is in the nuanced wisdom that is in the Finalised Guidance, that you cannot successfully match an investment recommendation with a client without credible research that quantifies potential loss.

At Synaptic we believe that Moody’s Analytics are the greatest experts in meeting this mathematical challenge, which is why we have built our risk ratings on their model, rather than the ‘qualitative’ assessment offered by our competitors. In our tools and when we publish our risk ratings, we include the regularly updated, stochastically forecasted loss that is expected in a bad year for that investment or portfolio. That gives the adviser a consistent research-based measure to back up their consideration of Capacity for Loss, and the means of setting the client’s expectations. In doing so, the adviser will avoid many pitfalls that poor use of tools presents.

Original content: Financial Planning Today Magazine