The need to take risk

Compliance, due diligence and therefore research are increasingly dominated by MiFID. Helpfully, the FCA published the PROD rules, which readers will recall are a set of guidelines designed to assist in the successful adoption of MiFID.

Speculation, more often than not, negates the value of regulated advice. Explore any failure of advice, and speculation will be at the heart of it…

Bound up in all the rules and regulation, is a very specific challenge that sits at the heart of modern advice – evidencing the 'need to take risk'. Getting this right is the most important factor in delivering reliable advice and meeting the Suitability requirements that have recently been reinforced by MiFID. Don't forget the regulator will rule against an adviser if the client has been exposed to too great a risk, even if he or she has made greater profits (!). The adviser does not have the luxury of timing the market, or relying on tactical shifts in a client's investment strategy to generate market returns. Many customers believe that this is a role that advisers perform, but it isn't. Advisers rely on optimising long-term strategies based on the predicted performance of diversified portfolios. The demise of Woodford has removed what was left of the allure of the 'star manager'. Now it is all about the objective study of the performance of asset classes.

Speculation, more often than not, negates the value of regulated advice. Explore any failure of advice, and speculation will be at the heart of it, whether it comes in the form of Barbadian resorts, Costa Rican Forestry or slick methods of peer-to-peer lending to start-ups.

A stock-in-trade for advice is the ability to provide the greatest possible certainty of outcome.

This is a fascinating challenge best met using probability-based forecasts. The latter can be used to define what the likely outcome will be – and these tend to be very accurate in stochastic models such as Moody's (formerly Barrie + Hibbert). The benefit of the Moody's model is that it will provide the likely (and historically accurate) prediction of the outcome of the investment but also the extent of losses than are to be expected throughout the term, offered as a 'Value at Risk' metric. This is invaluable as part of the discussion relating to a customer's Capacity for Loss.

We will see that it is very difficult to predict the outcome of an investment in the short term, but longer term, the power of probability kicks in and we can predict outcome much more accurately.

Using probability-based analysis, advisers can accurately and reliably align their client's plans to appropriate investment strategies defined by their risk and return metrics – so the 'need to take risk' is clearly understood by the client thus providing 'informed consent'. Financial plans are therefore achievable and realistic.

We will see that it is very difficult to predict the outcome of an investment in the short term, but longer term, the power of probability kicks in and we can predict outcome much more accurately. It is a similar explanation as to why a dice may have 1 out of 6 outcomes in a throw, meaning the next throw is impossible to predict. However, throw a dice 10k times and the outcome can be predicted with certainty.

Consideration of term

Term changes everything, including Capacity for Loss. The higher the Capacity for Loss, the higher the investment risk an investor can afford to take. Investment risk diminishes as the term extends, or, as 'Sequence of Return' risk is mitigated.

Establishing the client's long-term commitment to their investment term, (in conjunction with the A2R dedicated Capacity for Loss Questionnaire), will qualify the role of term in reducing expected overall losses, requiring less Capacity for Loss. The exercise relies on the objective judgement of the adviser. This secondary questionnaire therefore offers structure to critical discussion, and provides a format for recording the adviser's final recommendation on risk.

Customers have a lower capacity for loss when some or all of the following apply:

  • They have no way to replenish their capital (for example, no longer earning);
  • They rely on the investment for income in order to meet expenditure;
  • They have a short investment horizon (losses are unlikely to be recouped prior to crystallisation);
  • They are exposing a large part of their available assets to the risk of a fall.

How does term reduce risk of loss?

Over short time periods, an index such as a FTSE or S&P can deliver exceptionally high or low returns. If we look at the S&P 500, 1973 – 2016, the worst 1-year rolling return was -43% (to month ending February 2009). The best was +61% return (to month ending June 1983).

However, the worst 20-year rolling return was 6.4% (gain, to May 1979). The best rolling 20-year period delivered an average of 18% a year (to March 2000). So: you could argue that if you are going to be invested for 20 years, Capacity for Loss is irrelevant. The trouble is, that is not how compliance works!

The Ombudsman doesn't adjudicate on the ability of any sector, strategy or index to achieve profitability in the long term, despite often doing so. They adjudicate on the experience of loss in the short term (hence need for Capacity for Loss analysis). It may be appropriate to take on risk for the long term, but the risks need to be clearly explained and understood.

Rolling Stock Market returns / S&P 500 historic data

The beauty of asymmetric investment risk and return over time

Chart

The correct amount of risk

Example of an investment strategy employed by a Synaptic customer, mapped to Moody's asset allocation model. Extending the term allows you to recommend higher investment risk.

Adjustment of asset allocation according to term
Risk Profile of Customer 5 years 10 years 15 years 20 years
Very Cautious   1 2 3
Cautious   2 3 4
Moderately Cautious (low end) 1 3 4 5
Moderately Cautious (high end) 2 4 5 6
Balanced (low end) 3 5 6 7
Balanced (high end) 4 6 7 8
Moderately Adventurous (low end) 5 7 8 9
Moderately Adventurous (high end) 6 8 9 10
Adventurous 7 9 10 10
Very Adventurous 8 10 10 10
IDD Pension +1 IDD Pension +1

Range of investment outcomes

Measured between the 5th and 95th percentiles of the Moody's stochastic model, including 50th percentile value. Extract from full table. Values from Synaptic Modeller.

Asset Model All calcs from baseline of 100 Term Low Mid Max
All returns are nominal
4 1 year 88* 105 120
5 year 89* 125 164
10 year 98* 157 234
20 year 128 268 516
5 1 year 86* 106 122
5 year 85* 128 176
10 year 93* 164 263
20 year 123 290 628
6 1 year 84* 106 124
5 year 82* 130 186
10 year 90* 171 289
20 year 118 310 746
7 1 year 83* 107 127
5 year 79* 132 198
10 year 84* 176 316
20 year 112 327 845

*denotes projected loss in worst cases. NB 20 year projections 'worst cases' record gains.

For more information

If you have any concerns about your firm’s ability to meet the challenges of MiFID II, risk and proof of Suitability, consider adopting the Synaptic Risk proposition. You can use the ATRQ, Investment Strategy and Risk Ratings at our cost (free to you).

Call our sales team on 0800 783 4477.