One of the most fascinating books I have read on the topic of risk is The Flaw of Averages by Stanford Professor Sam Savage. It includes a cartoon of a drunk weaving his way down a road on either side of the centre line, with fast moving traffic whistling by, and the caption reads: “The state of the drunk at his average position is alive but the average state of the drunk is dead.”
Another cartoon shows a statistician drowning in a seven-foot dip while crossing a river he calculates is, on average, three feet deep. The lesson? Plans based on average conditions usually go wrong. Professor Savage operates in the world of project management but the same can be said of the world of financial planning – averages are often misleading and hide the often-significant risks that lie beneath.
In future columns, I want to explore investment risk and consider some important questions about what risk is, why it matters now more than ever, how it is perceived and how to successfully measure, monitor and manage risk with a common language between the client, adviser and investment manager.
I will look at why widely used measures – often expressed as averages – can be particularly unhelpful and why an independent standard that starts with the client rather than the manufacturer or the regulator is so critical in ensuring good client outcomes.
A client’s view of risk
In doing so, I will take a client’s view of risk – looking at how attitude, experience and capacity can impact investment planning and client behaviour and draw on some of the work we are doing with Henley Business School under our Government-funded Knowledge Transfer Partnership. This two-year programme is looking at the so-called ‘attitude-behaviour’ gap and is designed to significantly enhance understanding of how advised investors actually behave over time when faced with risk that manifests itself.
Given the increasing weight of assets owned by clients approaching or in drawdown, I will also look at the different types of risks clients seeking income face, including low-frequency/high-impact risks brought about by particular sequences of returns in combination with withdrawals and how to plan and manage mitigations to these.
Dynamic Planner expands risk labels for decumulation comparisons
The Financial Conduct Authority (FCA) is expected to publish its Assessing Suitability Review II this year and, in turn, this will be worth reviewing. The regulator’s last study – in 2017 – found that advice in investments, pension accumulation and retirement income was suitable in 93% of cases. There were two areas of concern however –defined benefit transfers and high-risk investments.
The FCA’s review is also expected to assess how well firms have implemented MiFID II, PRIIPS and Product Governance requirements. It would not be a surprise – given the issues with Woodford Investment Management last year and, more latterly, the M&G property fund – if some focus was given to liquidity risk, and this is certainly an important area to explore.
When it comes to managing risk in the institutional world, risk-adjusted return statistics abound. However what clients really want to know when reviewing their portfolio as part of their financial plan is: “Did I achieve a reasonable return for the risk we agreed I should take and am I on track?”
Frame and anchor conversations
What’s needed here are better tools to frame and anchor conversations between advisers and their clients – and advisers and investment managers – around value for money for risk taken and for these to be based on independent standards without each party using different metrics. The emergence of independent risk-based indices following the EU Benchmarks Regulation in 2018 facilitates the provision of such tools and means no one party is ‘marking their own homework’.
The availability of these tools and the focus on risk as the core principal of suitability is accelerating the movement towards risk-targeting strategies in multi-asset investing. Multi-asset is, according to the Investment Association, the only class of investments not to have seen a single quarter of net outflows over the last decade.
As its popularity grows, so too does risk targeting and so I will look at why this is – and the link with ongoing suitability regulations from MiFID II. There are many different strategies deployed to target risk and we will explore some of them. What is interesting is that, when executed successfully with portfolios that are consistently optimised to focus on delivering returns for an agreed level of risk, rather than on returns in isolation, the results can be very impressive indeed.
Impact of sustainability risks
No discussion of investment risk is complete without considering the impact of sustainability risks on portfolio and investment selection. This year, the European Securities and Markets Authority (ESMA) will complete its consultation on explicitly including discussion of environmental, social and governance risks in the investment advisory process.
Firms will also be expected to ensure staff possess the skills, knowledge and expertise for the assessment of these sustainability risks. Whether ESMA’s work reaches these shores post-Brexit is uncertain – however, the crucial role investment advisers play as gatekeepers for clients who want their investments to make a positive impact is clear.
Like Professor Savages’ statistician, it is important for investment advisers consistently to look beyond ‘averages’ and help clients understand the risk characteristics of their portfolio ‘under the bonnet’. I hope this column will help advisers and managers do just that.
Ben Goss is CEO at Dynamic Planner
