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February 4, 2011updated 10 Jan 2016 3:34pm

Risky Business

By Spear's

On a scale of eating day-old yoghurt to Russian roulette, how risky should your portfolio be? And does your wealth manager actually know? 
RISK IN FINANCE is not like risk in the rest of the world. There’s Russian roulette, where you have a one-in-six chance of making it through to the next round. There’s dropping a roast on the floor and serving it to your guests and hoping that no one notices or catches anything. And then there’s financial risk, where a wealth manager taps into a monetary ecosystem whose ratios and equations and exchange rates and surpluses and curves are so complex, interacting on such large and small scales, affected by global news and local moods, that it is almost impossible to be sure exactly what risk you are taking on.

If assessing that weren’t hard enough, matching it to a client’s risk profile is nigh on impossible. Wealth managers are scuppered by their clients’ own inability to explain their true positions and by the fact that client responses change dependent on who asks the questions and in what manner. Even accurate information is of limited value because risk profiling’s aim is to capture clients’ future prospects — and they change with every minute.

A recent FSA paper quantified the exact shortcomings. Of 366 cases investigated from March 2008 to September 2010, over half failed to correctly implement the client’s risk profile. Particular traps were not appreciating the difference between the perceived and actual ability to handle loss, and using poorly worded and inappropriately weighted questionnaires to establish risk capacity.

Prosaic? No. Highly important, which is why even firms who were not investigated in the report are emphasising the importance of risk profiling. ‘We ensure we meet and talk through with every client exactly how our two portfolios are invested and whether it is appropriate given their individual circumstances and attitudes to risk,’ says Alan Miller, CIO of SCM Private, one of the most innovative wealth management firms in the market.

In light of these problems, many firms use tools to guide their risk assessments. But when these were assessed by the FSA, it found that over 80 per cent showed ‘weaknesses that could, in certain circumstances, lead to flawed outputs’. Worse, ‘many firms do not understand how the tools they use work’.
SO, WHAT’S THE solution? First comes common sense. Gina Miller, founding partner at SCM Private, has plenty of it. ‘We do not employ theoretical arbitrary risk-profiling. Instead we focus on talking to clients face-to-face. The aim is not to simply complete the Know Your Customer documents but to explain in plain English our investment approach so prospective clients can properly ascertain whether it might suit them, their individual circumstances and attitudes. We do not hide behind investment jargon; we want our clients to understand everything we do and have 100 per cent transparency.’

The meticulous approach isn’t commonplace. By publishing the paper, the FSA has laid down an important marker in the evolution of the industry. The regulator’s active stance is born out of the fact that too often when confronted with market downturns, wealth managers make excuses rather than make good.

Designing the reforms has been no mean feat, however, as regulation, like investment, is a matter of balancing risk with return. In an era of political pressure for increased intervention, the FSA has taken a mature approach. In answer to the question, Is it the regulator’s role to shape the future of the industry or the industry’s role to shape its own destiny within the regulator’s parameters, the FSA has largely opted for the latter. Their paper is constructive yet flexible. It should not stifle the innovation needed to keep British wealth management a world leader.

One area to watch, however, is the side affects of the FSA’s retrospective approach of defining malpractice rather than best practice. This could lead to risk profilers becoming too cautious and ruling out perfectly reasonable fund choices. Such a result would harm portfolio performance and lead to client disenchantment of a deeper kind.

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The bottom line is that all parties have things to learn. Wealth managers need to remember that their tools are at best the basis for a fuller discussion of the client’s attitude to risk; a reality overlay is essential. HNWs must inform their managers of their news, as that is the only way that their risk appetite can be catered to. And the FSA must remember that overconfidence is a killer and that regulating on the assumption that advisers are omniscient is a recipe for disaster.

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