The GFSC has highlighted the confusion between capacity for loss and risk tolerance both in 2013 and 2015.
In its latest paper published last week Investment and Long Term Insurance Sales Practice the review notes: “It is not sufficient to simply ask the client how much they could afford to lose.”
The UK’s Financial Conduct Authority defines capacity for loss as “the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take”.
It has also warned on the confusion in 2011 and 2014. Of the investment files assessed as unsuitable between March 2008 and September 2010, the FCA rated half of these as unsuitable because the investment selection failed to meet the risk a customer is willing and able to take.
In 2017, the FCA said in its Assessing Suitability Review: “While the overall level of unsuitable and unclear advice is low, our review tended to identify issues in risk profiling – Where firms were not considering or mitigating the limitations of the risk profiling tool they used or where the recommended solution did not match the risk the customer was willing or able to take…”
Regulators in a difficult position
Greg Davies, a risk consultant with Centapse, said: “Regulators are in a difficult position when it comes to terms like risk capacity and risk tolerance attitude because, although they have used them inconsistently, if they were too prescriptive it would stifle innovation and be detrimental to clients’ interests.
“A very prescriptive regulator would paint advisers into a corner,” he argues.
For a decade Davies was head of behavioural-quant finance at Barclays before returning to consultancy in 2016 with Centapse.
Davies agrees with the GFSC findings that despite its central position in risk profiling too many firms are too broad brush or ignore it altogether.
Toward a common understanding
Davies’ solution is to ditch the labels and instead deal with the underlying issues.
“We need a crystal clear understanding of the crucial distinctions between risk tolerance, behavioural risk attitudes and risk capacity,” he says.
He defines risk tolerance as an investor’s stable, reasoned willingness to take risk in the long term and behavioural risk attitudes as “the unstable, behavioural, short-term willingness to take risk exhibited through an investor’s actions”.
Risk capacity chiefly concerns investors ability to meet future liabilities and is vital because the risk investors are willing to take might not be the risk they are able to take.
“Risk tolerance reflects the level of risk we should deliver for a client over the long term,” he explains. “Behavioural risk attitudes, in contrast, are transient and context-dependent preferences that result in poor outcomes if we mistake them for risk tolerance.
“They are not attitudes we should want in the driver’s seat for our long-term portfolio optimisation. The role of suitability is to steer investors toward better outcomes, not replicate (and optimise for) all the silly things they do already.”
The beginning of a conversation
Stuart Erskine a risk and behavioural finance expert with FinaMetrica, which builds risk tools for advisers, agrees there isn’t a common understanding for risk. He has co-authored a Risk Lexicon with an LSE academic.
“The advice industry still has a way to go to create a common language and a common understanding,” he said. “There is still a lack of common understanding between clients, advisers and between organisations. The lexicon isn’t a definitive guide but a starting point for a conversation; to help the industry move towards a common understanding and improved communication.”
Erskine finds this problem in client and adviser conversations, due to poor knowledge of clients and jargon used by the financial industry, can lead to a client walking away with a different understanding.