The risky business of financial advice

For financial advisers, the need to be able to assess their clients’ risk is assuming far greater importance, according to Gabriel Carey.

The financial services world as we knew it before the global financial crisis (GFC) has changed conclusively. This is evident in many ways, but three stand out.

First and foremost, matching performance achieved through the 1990s and the naughties – at least up to when Lehman Bros imploded in September 2008 – will be difficult.

It’s now more than three years later, and despite the market rally in equities in the immediate aftermath of the GFC, there’s no sign that investors (particularly in property and equities) have regained their nerve.

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The simple fact is any bullish news in the market (especially the Australian resources story) continues to be drowned out by what’s happening in Europe and the United States.

For Europe, in particular, the public debt story seems to go from bad to worse to nearly apoplectic, with the recent resignation of Italian Prime Minister Silvio Berlusconi just the latest potent symbol of this ongoing crisis.

Europe’s woes have taken some of the spotlight off the US, but no-one should doubt the world’s biggest economy has deep structural problems – of which unemployment (and the accompanying social ills) and public debt head the list. 

Second, expect more regulation of the financial services sector globally.

In Australia, there are Future of Financial Advice (FOFA) reforms, and that’s unlikely to be the last of it.

Governments are slowly responding to what’s perceived as the excesses of this sector before the GFC.

The mass protests across the world – called Occupy Wall Street – might be the most extreme manifestation of this public angst, but rest assured, this anger extends (in a far less visible form) across the social spectrum in developed countries worldwide.

What’s magnifying this anger, of course, is the amount of government support delivered post-GFC for this sector, and the perceived lack of social responsibility by the main players in response to this ‘public’ generosity.

Investors are far more indulgent of bonuses and greed when markets are rising, and all are participating; they are far less forgiving when the game appears rigged in favour of one sector.

Third, clients are more market savvy and less trusting of their financial institutions; crises like the GFC and the effect of individual corporate collapses such as Storm Financial do (unfairly or not) leave a mark on how investors view institutions and financial advisers.

These crises aside, it’s certainly arguable that the exponential growth in self-managed super funds – as well as the advent of 24-hour business television channels – reflects an investor sentiment that says they are wary of outside financial advice, as well as being more confident in making their own decisions.

And in the same vein, so does the movement away from managed funds to direct investing.

Pull these three factors together, and what emerges from the viewpoint of retail investors is a new paradigm about what they want from their financial institutions and financial advisers.

It has shifted quite dramatically from a world of returns and income to one far more focused on capital preservation.

Financial advisers are becoming increasingly aware of this phenomenon, and are having to respond accordingly.

In this brave new world, being able to quantify risk assumes far greater importance; clients paying more attention in trying to assess whether their portfolio will lose capital (irrespective of market conditions) than earning a return above the market benchmark means they will demand a different skill set from their financial adviser.

In other words, traditional client discussions using rules of thumb for risk and concentrating on the return or dividend side of the equation.

For example, using estimated returns to illustrate asset allocations such as a balanced fund should achieve a 7 per cent annual return – are assuming less importance for investors who understand that even a 7 per cent return goal can require significant risks to achieve.

For many financial advisers who have relied on the rule of thumb, it’s a skill set they simply don’t possess. In many respects, that’s not their fault.

It reflects a retail investor culture where the focus has been on returns rather than the risk/return balance.

And as the GFC graphically illustrated, many institutional investors that had risk strategies built into their portfolios did not exactly cover themselves in glory when the financial markets imploded in 2008.

In the first instance, what financial planners have to do is determine from their clients their risk tolerance – how much are they willing to lose.

If, for example, the market falls 10 per cent in a month, how will their share portfolio look in such a downturn?

Will it be off more, less, or simply match the broader market index?

What if the market falls 20 per cent?

Using statistical analysis tools, financial advisers can assess – to a fair degree of accuracy – how a client’s portfolio is likely to behave in such market downturns.

As returns become harder to generate and the current economic environment in Europe and the US settles in as the norm for the foreseeable future, a focus on risk will be needed to meet retail investor needs.

By quantifying possible losses and risks, a retail investor (who is well aware that investing means taking risks) will be able to understand the expected performance of their portfolio – and not only in good times.

For some financial advisers, factoring in risk expectations of clients’ portfolios will require a significant rethink of how they explain and review portfolios for clients.

But they have no option. In a post-FOFA world, and with returns unlikely to offer positive numbers with any degree of consistency, it needs to become an integral part of their service offering.

Gabriel Carey is regional manager for Victoria, South Australia, Tasmania and Western Australia of the boutique investment house, Instreet Investment.