Risk profiling, the hidden dangers of journey risk, and the Three-Body Problem

The FCA’s much anticipated Retirement Advice Review dropped last month, gobbled up by compliance guys like a surprise 31-track Taylor Album, but for men in elasticated chinos.

It actually wasn’t a damning read. Sorry car crash fans. The majority of files checked were suitable and areas of good practice were highlighted, including the use of cashflow software, which has been a low-key game changer for advice firms building out their decumulation advice capabilities. Its ubiquity is a big part of the reason advice has become professionalised to the point where I wouldn’t even feel embarrassed telling people what I do for a living at parties (if I ever got invited to one).

What wasn’t so good was what it said about risk profiling, which it found was “often not evidenced, was inconsistent with objectives and customer knowledge and experience, or lacked consideration of capacity for loss”.

I almost spat out my hipster cortado. Isn’t this Sesame Street stuff? The idea that an adviser has stuck someone’s life savings in a bunch of tradeable securities without being able to evidence an understanding of their risk tolerance seems insane.

Having racked my brains over this, I think the problem probably falls into two categories. Advisers who think they do it when they don’t, and advisers who reject the whole thing.

The first lot may have decided Attitude to Risk Questionnaires are pointless rather than problematic. Sure, they’re a pain, riddled with bogus science, loaded descriptors, motivated distortion. Attitude to risk is of course a highly subjective measure. Units of risk tolerance don’t translate neatly into units of portfolio volatility. But combine the imperfect methodology with an imperfect understanding of the client before you, deploy your imperfect questioning skills, and you’re getting somewhere. I’ll come back to this.

I think capacity for loss is still badly understood. If you use cashflow planning it’s really press of a button stuff, so there’s no excuse to ignore it. And if you don’t use cashflow planning then you should probably stop advising on retirement income. Again, Capacity for Loss is flawed. We know catastrophic loss without reversion to the mean isn’t likely. But that’s not the same as saying it isn’t worth measuring and using to help educate your client.

The second group is a challenge. I read some old tosh the other day about how an adviser’s job is to ‘encourage’ clients up the risk spectrum into higher equity exposure then keep them in their seats. You hear a lot of this from a particular noisy subset of advisers. It does trouble me, as I think it stems from a fundamental inability to put yourself in the client’s shoes, with a big side of main character syndrome. Any idiot knows how to get the best investment returns, once you eliminate the obvious stuff like high-cost price speculation. Just shift your asset allocation up and to the right and look away for a few decades. By the narrowest measure this is the ‘right’ thing for every investor. Just lie back, get ‘encouraged’ up the risk scale until you’re holding 100% risk assets, allow yourself to be coached through a couple of nervous breakdowns, then watch the stupendous returns pop out the other end. Happy days. But wait. What if that means 30 utterly miserable years of being forced to think about the most boring thing in the world, your finances, every single day? Who wants that? Advisers need to have a bit of humility. Journey risk matters, and saying I told you so doesn’t erase a lifetime of bricking it every time you see a red chart on your phone.

I think the best we can do is try to gain an imperfect understanding of a client’s highly subjective, largely irrational feelings about investment risk. Then combine that with various imperfect measures of their capacity to take risk. Then use this to educate them to the point where they can make good decisions about the right approach for them, accepting that there really isn’t a best solution, it’s all just trade-offs. Returns come at the cost of a reduction in certainty of outcome, and (probably) some degree of emotional discomfort.

In The Three Body Problem a mathematician describes how Monte Carlo analysis is used to calculate the area of irregular shapes that can’t be solved using integrals. Instead, you stick the irregular shape inside a regular shape with a known area, throw a load of random points at it, then count how many points fall inside the irregular shape. Risk profiling is essentially the same. Throwing a load of imperfect measures at the problem gets you as close as you’re going to get to the answer. It’s not perfect but it’s better than nothing. And definitely better than ‘be miserable and stay in your seat’ or ‘attitude to risk questionnaires are for squares’.

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This article originally appeared in Money Marketing, May 2024