Risks in risk

Understanding clients’ attitude to risk is more difficult than many in the industry seem to have thought, says Teresa Hunter

Funnily enough, such whines are thin on the ground when markets are rising. But the minute the current financial crisis broke, the sound of collapsing banks was almost drowned by wailing investors calling their advisers liars, cheats and scoundrels.

In some cases, they were within their rights. If some with holdings in the AIG enhanced fund, are to be believed, they were given the impression their money was held in a simple deposit account. Why it could pay a higher return than all other deposit accounts never seems to have troubled their precious little heads. Naturally, they were stunned to hear they couldn’t get half their money back for three years, because it was invested in a bond fund, which was under pressure.

But there were many examples of clients who were placed in all kinds of structured products they claimed not to understand, until these investments failed. I have to say, though, the speed with which they get to grips with every minute detail, ex post facto, is truly impressive.

It used to be all about commission. More recently, I suspect, excessive risk-taking has been as much about trying to provide a decent pension at a time when a crab-like stock market moved ever sidewards, and returns in general were pitiful.

The credit crunch, though, has changed everything. It exposed the grim reality that there is no such thing as a safe investment. Banks crashed as did bank shares. Bond funds looked as sick round the gills as many equity funds.

Who can blame unsophisticated investors who specifically said they could not tolerate a loss of capital from feeling cheated.

And if there is one thing the brave new FSA can’t bear, is cheats, so it’s decided to stamp its feet.

In future, advisers must fully understand a client’s attitude to risk. This applies equally to corporate as well as individual advisers, where companies invite consultants into their firms to make pensions recommendations to staff. Often they will use risk-profiling tools, which automatically calculate a client’s risk score, by feeding the answers to a questionnaire into a computer programme.

Yet the watchdog found that many of these tools were vague and poorly understood by those using them. Out of 11 such processes it assessed, nine were seriously flawed. Advisers didn’t understand how to use them, or misinterpreted the results. Even where the tools did assess the client’s risk threshold correctly, the watchdog found that many advisers still went on to pick an inappropriate investment.

Well, it looks like their days are numbered. Advisers can no longer rely on risk assessment tools alone to justify recommendations but must specifically quiz the client about how much loss they can stomach. They must then interpret the answer sensitively and accurately. In other words, they must “know their customer”. Now there’s a novelty.

The watchdog has published draft guidance requiring firms to tighten up their procedures significantly, which may involve some firms in radically overhauling their processes. The upside is that if firms follow the guidance to the letter, it will give them greater protection against spurious investor claims. But it will still place advisers in a quandary. If the customer states clearly he cannot stand any capital loss, or, say, only 5 or 10 per cent, what is the adviser to recommend?

We now know, in the light of the credit crunch, that there is no investment which can offer an absolute guarantee of no loss, outside a bank or building society; and even this is a moot point.

So, it looks like building up that pension pot just got a whole lot harder.