 By Paul Resnik, Co-founder and Director of FinaMetrica
It's difficult to trust someone who delivers negative surprises. What we see in the successful branding of cars and clothing for instance, is a consistency of client experience. Be it premium or utilitarian, purchasers mix and match based on their needs and perspectives; e.g. “I need a premium car because I have five children to chaperone around but 'Marks and Sparks’ will be fine for my underwear”.
In both cases I am likely to be a happy customer if my expectations have been met. My trust in the brand's promise is maintained or weakened by my expectations compared to my experiences. If I am happy, I am more likely to buy again.
It's much more difficult to develop and hold trust in investment management than in consumables because the differentiating quality of the investment experience may be revealed in only one part of the investment cycle, sometimes several years ahead.
However another method of differentiation that can bring greater profits to investment managers and advisers is to better frame investment expectations. Consequently, investment managers and advisers need not rely on increased sales for more profit, as the reduction of investment surprises will likely lower the volume of withdrawals from dissatisfied, unhappy investors.
The application of psychometrics, the scientific method of assessing personal traits such as financial risk tolerance, is the starting point of a better advising and communication process. Psychometric integrity of the test ensures the quality of the next step; the accurate mapping of risk scores to portfolios. This is a critical component of the investment suitability process. In turn this provides an effective environment to diminish the likelihood of clients saying " I didn't know my portfolio might fall by that much".
Many risk tolerance tests in the market don't actually assess risk tolerance. They often include questions relating to other matters including risk perception, risk required, time horizon, capacity for loss, and investment experience. Weightings are given to the answers and the final score converted into an investment recommendation.
These tests are flawed from inception, with the main driver being speed to an investment recommendation, rather than an accurate assessment of risk tolerance as a necessary part of the process leading to a suitable portfolio.
A little reflection tells us that while the recommendation from such tests may be correct for some, it won't be for others. For example, an individual may have a naturally high risk tolerance, a low capacity for loss because of other obligations, a long term investment horizon and little investment experience. Each factor can lead to a different investment recommendation.
As we know individuals are complex, and their lives and circumstances don't fit into simple boxes. Personal involvement and conversations weighing-up and making the trade-offs of any conflicting differences between the asset allocations consistent with each circumstance are critical to investment advice that meets the client's needs.
Investment managers and other providers who offer risk tolerance tests to advisers can support adviser's professional obligations by:
• Providing a certified psychometric test to give an accurate assessment of an individual's financial risk tolerance.
• Delivering an evidence based link from the individual's risk tolerance score to asset allocation.
• Encouraging a methodology for taking into account risk tolerance in the investment suitability process which also includes explicit recognition of risk required, time horizon, capacity for loss, and investment experience.
• Promoting a common set of terms to describe risk. Risk terms are traditionally used interchangeably, with little consistency and with different meanings. What does risk profile mean? Is it the same as an investment profile? Is it used to describe an individual or an investment? What does risk tolerance mean? How is that different, if at all, from attitude to risk? What does risk capacity mean?
• Applying a standard approach to the illustration of volatility and possible returns.
Over the longer term well-run portfolios have tended to maintain their purchasing power plus a little more depending on their tax efficiency and fees. We know that extreme volatility always happens. When markets are running, untethered investors tend to want to run with the herd; acquiring more growth investments when markets have risen strongly, and selling when in decline. Illustrations need to show that these highs and lows happen often, and while their timing is rarely predictable, their inevitability is.
An adviser's greatest value is helping clients select the portfolio that is likely to meet their needs and manage their expectations, so that temporary disappointment and euphoria do not diminish the value of that selection. Consequently, investment managers’ and advisers’ profitability will benefit from greater persistency. Investment managers are increasingly working with advisers to develop robust mapping of risk scores to portfolios. It’s not an end in itself. But it's a good start to the new client-centric world of 'no surprises' which is integral to the creation of trust.
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