For years, some might argue, the role of risk in financial planning was played down. Solutions packaged and institutionally managed by providers provided automatic cover for risk, unlike in today's open architecture world. Things seemed more straight forward then, and volatility felt like an acceptable proxy for risk. 'Vol' could be broadly relied on to rank asset classes and therefore investments to produce a Markovitzian efficient frontier. So, what changed? The FCA handbook now specifically states that volatility cannot be used as a sole proxy for risk.
Five years ago, the word 'stochastic' was a bit of joke to many advisers and commentators alike. But you don't see the same kind of dismissive articles written now, referring to 'roulette wheels' and 'pseudo-science'. Articles regularly joked at the absurdity of relying on a questionnaire in helping to assess the 'unique' circumstances and therefore advice relating to individual clients. You don't hear this so often now, as an appreciation of the real grounding in demographic research and mathematical modelling has grown. It's not true that you will get a different outcome every time you use the questionnaire, as detractors used to regularly claim. It's true that you can't predict the outcome of a toss of a coin, but do it 10,000 times or more and you can be certain. Some of this certainty can be harnessed in the best asset class return models that use mathematical simulation, such as the Moody's Analytical model found in Synaptic.
This has a proven track record over decades.
The benefits of working with psychometric questionnaires and probability-based models are becoming more and more self-evident. It was only a few short years ago that the star managers ruled the investment firmament, but they do not carry the sway that they once did, as the age of information has levelled the investment playing field to such a degree. It is asset allocation that drives investment and reliable returns more than ever.
It's always worth going back to the source to remind ourselves of the core of compliant advice and suitability. FCA COBS 9.2: (1), where
"A firm must take reasonable steps to ensure that a personal recommendation, or a decision to trade, is suitable for its client."
It goes on to stipulate that said personal recommendation must
- (a) meets his investment objectives;
- (b) is such that he is able financially to bear any related investment risks consistent with his investment objectives;"
Much of the thematic work that the FCA has undertaken has lamented the lack of research and due diligence to support these two stipulations. The quality of outcomes has not been an issue, but we have of course had a brilliant environment for investment since the downturn of a decade ago. When things take a turn for the worse, the ability for customers to appeal for redress on the basis that they were ill-judged for risk will be devastating for some advisers, unless they embrace the best of the latest research-based risk management. The regulator defines the ability to bear loss as whether it materially impacts their standard of living, and is enshrined in the concept of 'Capacity for Loss'
The hardest thing seems to be the inability for some advisers to separate the Risk Profile (which is concerned with the emotional relationship between Risk, Reward and Loss) and what may be an appropriate risk category for an investment objective. To our knowledge, many advisers attempt to marry the Risk Profile of the customer with all the recommendations they may offer. This is wrong, as risk is therefore not aligned to objectives. A simple way of underlining this truth is to remind ourselves that a customer has a single risk profile (that may or may not change over time). They may, however, have several elements to their financial plan which are managed at different risk profiles to their Attitude to Risk profile and are different to each other. Consider the Balanced investor who has their main pension savings in an Aggressive strategy and their ISAs invested Cautiously. Perfectly sound. They may be young, saving for their house deposit in the short-term through their ISAs, and several decades away from retirement.
The majority of income for advisers is pension related, so getting accurate growth assumptions and predicting losses correctly has to be better than 'robust'. Our knowledge of sustainable income in retirement, strategies for investment to accommodate longevity and lengthening retirement are proving time and again the importance of getting the maths right, and this can only work using reliable mathematical models such as Moody's Analytics. The need to monitor in order to adapt plans as necessary means that the old-fashioned advice by numbers and culture of 'set and forget' is redundant.
The modern adviser must have auditable processes in place for all of the above, and this is easy if you adopt a comprehensive approach such as the Synaptic Risk proposition, built around the Moody's Analytics stochastic model, to which, uniquely, full access is given using the Synaptic Modeller tool. This means that you, as an adviser, can measure the 'Value at Risk' in a portfolio or fund, and make credible and reliable projections for growth using the model. There is no other way of capturing the full range of possible outcomes of a given investment. With Synaptic you can access the ATRQ, the investment strategy built by Moody's and Risk Ratings for many of the leading investments for free. This is an easy way to help demonstrate your expertise, improve your compliance and protect your Achilles heel.
Our illustration compares our baseline strategy (Adventurous) to an investment recommendation. Using a term of ten years in this case, we can plot the probability attributable to different outcomes. The 'Minimum gain' clearly states the % loss my client can expect in a bad year (defined as 1 in 20, that is to say 5% of the worst outcomes from the model). 'Capacity for Loss' can be clearly put in context (and accommodated).