Will risk profiling protect you?

With markets falling we will now see whether the theory of risk profiling works, and who will have to pay if it doesn’t.

The promoters of risk profiling have argued it is a necessary component in liability management. Presumably this implies several things: that profiled investors will never complain about their portfolios’ volatility because they have been tailored to match their personality; and that any potential claim from a disgruntled client can be defeated on the grounds that the portfolio was matched to their profile.

Advisers will be testing the first of these propositions every day when they meet with ‘high risk’ clients who have been put in high risk and therefore high equity portfolios. If they find that investors who were supposed to remain calm during major market collapses are upset, presumably it means that the tool was ineffective.

There are numerous methods of risk profiling used by planners, some of which are highly intuitive and others that purport to be scientific. Whichever method you use, if your clients are reacting as predicted, then it is proving its value. If they are not, its value is being disproved.

But will profiling prove a sound defence against a liability claim?

At the time of writing, the MSCI World Index had declined by more than 40 per cent from its peak.

Take the case of Mr X, who had the dual misfortune of investing at the peak and having been determined as a high risk investor.

He was heavily exposed to the stock market. Consequently he is much poorer today than he would have been had he been given a more diversified portfolio.

He lodges a claim on the basis that he was given poor advice in regard to lack of diversification, that it was professionally negligent to have invested heavily in overpriced stock markets and that his personality type is not a justification for bad asset selection.

Further, he asserts that the risk profiling tool was inaccurate in his case, and the adviser incompetent in selecting or applying it. As evidence he states that he is unhappy (he’s probably in the best position to know this) and the tool claimed he would not be.

The adviser will have to demonstrate that he had sound reasons for believing that the risk profiling tool was accurate — notwithstanding the contrary example on the other side of the courtroom. It is hard to imagine what proof can be tabled for this given there had been no material market downturn, prior to the recent one, since 1994, so there has actually been no opportunity to verify whether the tools are precise or completely useless in predicting which clients can cope with volatility.

Incidentally, the claim may include the allegation, which I have actually heard a QC use, that a planner is negligent to take into account the wishes and preferences of a client in portfolio construction, but rather should confine advice purely to meeting the client’s financial needs.

The QC argued that to take personality into account was analogous to a doctor believing a patient needed an operation, but recommending tablets because he thought the patient would feel more comfortable with that treatment.

This claim resulted in the professional indemnity insurance company settling. Most vigorously pursued claims — reasonable or otherwise — are settled by the insurer, so let’s assume this is also the outcome for Mr X.

Say the planner had purchased a risk profiling tool and relied on it in preparing advice. The interesting question will be whether the planner (or the insurer) pursues a claim against the promoter of the tool, which purported to ensure that all recommendations would be appropriate to the client’s personality or legally defensible.

It would be hard for the promoter to argue that the tool had not contributed to the advice if it had previously argued that its use was essential in determining recommendations.

A possible danger behind risk profiling is that it can lead one to think that, if clients can cope with risk, they should be given it. Yet even a high risk profile investor would surely have preferred the superior return from bonds and property, over the last two years, than losses from equities.

I am not pretending that planners can always know in advance which asset classes will perform best. However, an assessment of the possible relative performance of assets is relevant in portfolio construction for all individuals.

Profiling is usually, though not always, used to develop recommendations that are a compromise between those appropriate to the client’s financial position and those appropriate to their psychological position.

The planner’s problem, in defending a claim, is that it must be acknowledged that advice has not been based solely on the client’s financial position and the adviser’s view on markets but also on the client’s purported risk profile.

It may not be a comfortable position for a financial planner to explain that he chose to invest heavily in the stockmarket on behalf of a client, not because he necessarily thought that it was an exceptionally good time to enter it, but because he believed that all people of a certain type should always invest heavily in the stock market, irrespective of market conditions. (I acknowledge that not all planners use profiling in this way, but many do.)

Personally, I think this would be a negligent position to take. Hence there is the possibility that some judges would also.

I believe a planner’s role is to work out the advice most appropriate to the client’s financial needs. If it is believed that the volatility inherent in that advice could be too challenging, then this needs to be explained to the client, including the extent to which the advice has been compromised to accommodate that.

On the other hand, if the advice that is considered most appropriate to the client’s circumstances involves relatively low volatility then it should be given, even if the investor is a real adrenaline junkie.

However, this is a minority view. Many planners have accepted the theory that it is possible to determine, psychologically or scientifically, how individuals will react in market downturns, thus eliminating client complaints and claims for compensation.

They will currently be verifying the accuracy of this expectation. No doubt there will be a wide range of experiences for different planners in this regard, including some who are feeling very comfortable with their processes.

However, those who are finding that their clients are shocked by recent market events should not only be re-thinking portfolio construction principles, but whether their risk profiling methodology has contributed to this.

In a worse case scenario, where a client makes a claim, it will be most interesting to see if any lawyers or insurers form the view that planners received misleading representations about the capacity of risk profiling tools.

Robert Keavney is joint chief executiveofficer of Centrestone Wealth Management.