An interesting case emerged in the UK this week where a client complained to the financial services ombudsman over there about an investment they were sold by a life company back in the year 2000. The basis of the complaint was that the €8000 they invested in was placed in investments that were too high risk for them.

This is interesting from an Irish perspective because the problem in this instance for the client and arguably for the life company providing the advice is not unique to the UK. In fact, matching suitable investments to clients is a worldwide issue and something that I believe is only handled well by a very small number of advisors.

Regulation, here in Ireland, and any other market I have studied basically works on two key principles. Your advisor must “know you” i.e. get enough facts about you to be able to establish the second principle which is to give you “suitable” advice.

Different jurisdictions will then apply these principles in different ways. But essentially an advisor must know about you and then give you suitable advice.

When we look at the provision of just investment advice getting to know you can be simply about the basics. How much do earn, how much do you spend, how much do you owe and how much stuff do you own. Some other things a planner should establish would be around dependents, health, previous experience with financial products etc.

Good planners will of course go well beyond this and get to know you better, but if your advisor ticks these boxes it is likely they are close if not fully compliant.

Providing “suitable” advice then is a little more open to interpretation. The regulation in Ireland states that an investment must be suitable to the consumer in terms of:

5. 1. a

  • i) the length of time for which the consumer wishes to hold a product,
  • ii) need for access to funds (including emergency funds),
  • iii) need for accumulation of funds.”

Another important thing, and the basis for the complaint in the UK was around whether or not the investment was at an appropriate level of risk. Our regulation here mentions risk in this context:

  • 5.1.D where relevant, attitude to risk, in particular, the importance of capital security to the consumer.
  • 5.19.C iv) how the risk profile of the product is aligned with the consumer’s attitude to risk;

There are other references to attitude to risk in our consumer protection code however the theory is that any recommendation must be “suitable” to you the investor. The practice is however that the majority of advisors, bank and investment houses, in my opinion, fall short for you the client in establishing what is suitable.

Yes they will establish the “facts” about you, and all the things mentioned above about your circumstances. But when it actually comes to matching those facts to suitable investment products the bridge is weak.

Psychometric tests were introduced over 20 years ago to bridge that gap and more recently have become readily available to advisors and even direct to public on websites from investment houses and life companies.

The idea behind them is you answer up to 25 questions about your attitude to risk.

In simple terms, psychometric means that the questionnaire asks you the same questions in different ways to see if it can get a consistent answer.

When you are finished the questionnaire the system spits out a number. This tends to be a number between 1 and 7. 1 being a very cautious investor and 7 being a very adventurous investor. The problem is most firms stop here and then map your investment choices to this number. Handy enough then that investment funds under EU regulation are all classed from a 1-7 basis! It is called the ESMA scale.

Getting this number for you in my opinion is simply testing you to see how much pain you are willing to take with your investment and then simply giving you an investment that will inflict that pain on you.

I also find it more than a little ridiculous that you would design an investment purely based on somebodies attitude to risk. With nearly 20 years of advising clients I have learnt something, clients want to control risk on the way in, but only want to know about their returns on their way out.

I never have had , nor do I ever envisage a client discussion at any stage in my career where a client will say to me “tell me Eoin how was the risk controlled on that investment in the last ten years” all people want to know is “what was the return like on that thing I invested in”.

There are two other key components that need to be considered when you are taking out an investment. They are what is your capacity for loss and the one which, again in my opinion, should carry most weight of all of them is what is your required rate of return. To me the three things have to be taken together.

Capacity for loss

This is basically a measure of how much of a hit your investments can take without you being knocked out. In other words, how much will it go down by before you have to pull the plug because you cannot afford for it to go down anymore. When we are advising clients, we test this figure for them, we see what impact another 2008 would have on their investment and if 2008 happening all over again would wipe them out financially. If a repeat of 2008 would wipe them out we take a more conservative approach to their investment portfolio.

Required Rate of Return

This is the big one, If you have a high capacity for loss and a high attitude to risk but it turns out that you can do all you want to do with your life with a very small amount of return on your investments then why would you even consider taking the higher risk when you don’t need to.

Conversely if you are very conservative with your attitude to risk and have a low capacity for loss but your life plans suggest you need to take more risk in order to get a potentially higher return to achieve your goals, then you either need to adjust your plans or be willing to chase those higher returns.

My point here is the industry, in general, is falling short of what is required. Cases like the one in the UK will continue to be taken and will continue to be won by the people taking them until such time as the industry really starts to get to know their client but starts mapping the clients wants and needs to their requirements from their investments. And then when that is done they back test, back test and back test again to make sure the financial plan is bullet proof and the investment is suitable to you.

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