Over the years since the Financial Services Authority carried out its thematic review of consumer risk profiling, there have been some useful developments.
Risk profiling questionnaires are now more reliable (most are statistically tested) and capacity for loss is assessed. However, these are little more than first steps.
Little real progress has been made with the vitally important next step of building investment solutions that match consumers’ risk profiles and deliver on their objectives.
For the most part, all the financial services industry has done is to use a volatility measure as a proxy for risk.
This is very convenient for fund managers because it is easy to measure and relatively easy to control, but as a risk measure, it is not at all relevant to most consumers.
Imagine a curious world in which all a taxi driver needs to know when you get into his or her cab is how fast you want to go.
Well this is very close to where we are as an industry when we produce risk-rated or target risk fund solutions based on volatility and map these to consumer risk profiles.
The current risk profiling methodology helps us understand the speed at which the passenger in our “investment vehicle” feels comfortable, but takes no account of where our passenger wishes to go and when he or she hopes to arrive.
The where and when questions are obviously vital and key to understanding the risk of not arriving at the right destination on time.
Just as the passenger in our surreal taxi is unlikely to arrive at the desired destination on time, so too will a consumer invested in a risk-rated or target risk fund, likely to be disappointed with the outcome in terms of meeting his or her objectives.
The most common cause of complaint about an investment is that the outcome has not been what was expected by the consumer. Volatility in the price of an investment might cause concern (even sleepless nights in the extreme), but does not lead to loss or failure to meet an objective unless the concern leads the consumer to bail out at the wrong moment.
By focusing on volatility the industry has chosen to focus on a convenient but, largely, irrelevant measure of risk. Consumers’ concerns are generally focused on outcomes, and volatility is a very poor proxy for a real-world outcome.
Indeed, part of the adviser’s job is to help consumers understand that markets are volatile and the importance of holding their nerve in order to achieve long-term objectives.
Just as speed is not a risk – the risk is of a car crash, so neither is volatility. The real risks that consumers face are:
• Capital loss on early disinvestment;
