Establishing investment risk
The Financial Services Authority (FSA) has today published a Guidance Consultation Paper on the subject of assessing suitability when it comes to establishing the risk an investor is prepared to take with their money.
This is a really important subject and recent examples in the retail financial services sector show just how seriously many advisory firms need to take this guidance consultation.
The FSA paper covers three main areas; establishing the level of risk an investor is willing and able to take, the selection of suitable investment funds, and adopting third-party tools.
As a firm of Chartered Financial Planners, we have developed our own robust investment advice process to ensure that our clients receive consistently suitable advice. It was interesting to read the FSA paper this morning and identify many of the same messages that we have integrated within our advice process.
The FSA is concerned that, whilst most advisers consider attitude towards investment risk, many fail to appropriately consider capacity for loss before making investment recommendations. This means the ability of the investor to absorb falls in the value of their investment.
Our investment advice process starts with a detailed understanding of a client’s current financial position and future financial goals. It is only by knowing these two factors, in detail, that an adviser can ensure any recommendations made are suitable, with consideration given to capacity for loss.
This approach, combining Financial Planning with investment advice, is far superior to the investment-driven approach we understand many advisers prefer to take. Without establishing goals and objectives first, before providing investment advice, it is simply not possible to ensure that investment advice is suitable.
The FSA also has some concerns about the risk questionnaires used to collect information from investors. They point out that such tools can aid discussions with investors, but have limitations when used in isolation. We agree entirely.
Our use of a risk profiler questionnaire is always the starting point for a more detailed discussion about investment risk, reward and volatility with a client. We sometimes find that investment questionnaires produce incorrect results if not supported by these more detailed discussions, highlighting the importance of combining the two approaches.
What the use of a risk profile questionnaire does achieve is a consistent approach to assessing an attitude towards investment risk. It also tends to prompt various questions – “Why do you feel that way about your answer to question fourteen?”. This is where the skill and experience of a professionally qualified adviser adds significant value to the understanding of investment risk.
The FSA reported examples of firms failing to have a robust process to identify investors who would be better suited placing their money in cash deposits, because they are unwilling or unable to accept the risk of loss to capital.
In our opinion, this failing is partially due to a failing of the old commission-based remuneration system, which is being abolished at the end of next year. An adviser who is only remunerated by commission when he or she sells an investment product is less likely to recommend a cash deposit, simply because this option does not pay a commission.
This is an example of how commission has the potential to skew the delivery of investment advice.
There is also criticism within the FSA paper about how advisers select suitable investments, once an attitude towards investment risk has been established for a client. Within this section of the paper, the risk of using automatically generated investment selections is highlighted as is the failure to recognise the importance of considering diversification.
This also comes down to an adviser and their firm having a consistent investment process, with a robust investment selection process in place to identify and monitor the investments they select. We would encourage every investor to ask their investment adviser to describe their investment selection process, in detail, to ensure a robust process is in place and being used consistently.
We hope that the publication of this paper from the FSA will help investors to identify best practice and ensure their adviser has no gaps in the process they use to deliver suitable investment advice. As a firm, we look forward to debating the contents of this FSA paper in full at our next Best Practice meeting, as part of our commitment to continual improvement.