Focus on a client’s needs – not their personality

Adelaide-based financial planner David Middleton has called on the industry to come up with a risk-profiling process that puts the client’s needs first or run the risk of having a process thrust upon it by the regulators.

Speaking at the recent Certified Financial Planners (CFP) conference in Sydney, Middleton said the regulators are very serious about protecting the public from risk, which in the regulators’ view translates to the risk of losing money.

“The regulators want to be proactive. They want to reduce the chances of someone being hurt before the fact rather than finding someone to blame afterwards,” he said. “For this they need adequate paradigms for responsible advice and their problem becomes our problem if they choose the wrong one.”

Middleton warned the industry to get its collective act together and come up with a consistent approach to risk.

“We have to resolve for ourselves as an industry our processes so that we don’t get stuck with processes that we don’t believe in purely to satisfy compliance obligations,” he said.

“We need to contribute to industry process otherwise we’re going to find ourselves sucked into somebody else’s and we’re not going to like it.”

Middleton said that at the moment great emphasis is placed on determining the client’s investment personality.

“It’s not uncommon for advisers to believe that appropriate advice is somehow trapped in the personality of the client and we will be successful and safe if we can somehow unlock it,” he said.

However, he said advisers might be better served working on the premise that clients hate losing money more than they love making money.

“Clients especially don’t like their investments going down to be worth less than what they paid for them,” he said. “If we assume that all of our clients are risk-averse then we don’t need to unlock their personalities.”

He said current regulation requires advice to be consistent with a client’s risk profile but there are currently no less than three approaches to risk profiling in use across the industry.

The first is based on a simple questionnaire that categorises clients on a spectrum from aggressive to conservative. The category into which a client falls determines their asset allocation and stock selection.

“This technique is at the very least of questionable value,” Middleton said. “And yet if you have a claim against you with the Financial Industry Complaints Service (FICS) and you haven’t done this, then you may very well lose.

“We even teach people in our own diploma of financial planning (DFP) courses and at universities that if they do this sort of risk profiling, everything will be terrific, with the implication that it represents industry best practice.”

The second and perhaps most common approach to risk profiling is to use one of the tools currently available in the market to gauge a client’s tolerance for volatility and for financial risk generally.

Middleton says this approach has the potential to be useful.

“The idea is to develop useful and consistent tools that help us to understand a client’s tolerance for volatility and also their tolerance for financial risk generally.

“I think activity in this area should be encouraged and it should be applauded. If we can understand before we deal with a client whether or not they’re prone to regretting decisions that have gone wrong, then it may not change the advice that we give them, but it may change the way in which we advise them and how we communicate with them and how we educate them.”

However, Middleton questioned whether this second method of risk profiling is the best way to go about it.

“Should this [method of] risk profiling be required as part of the risk management process? Before you answer that question, I think you should ask another — is it possible to give responsible advice, without doing this, and I think the answer to that question is almost certainly ‘yes’.”

Middleton advocates the third form of risk profiling, which focuses entirely on the client’s financial circumstances and requirements.

“The appropriate asset allocation and stock selection is largely determined by achieving a reasonable degree of certainty that a client’s objectives can be achieved in most foreseeable circumstances,” he said.

“Many others and I believe that it is possible to give responsible advice based on a thorough understanding of a client’s circumstances and goals and it’s possible and it’s practicable to embed this approach in a distributable process.”

Middleton said the industry’s primary obligation is to implement meaningful processes for managing client risk.

“Once we have decided what they are, the processes really need to enjoy broad industry support from the advisers, from the regulators, from the suppliers of services like the research houses and software suppliers, and also from fund managers.”