I was pleased to see Robbie Bennetts’ call for an industry-wide debate on portfolio construction responsibilities. Never one to miss an opportunity to express a view on issues that are critical to how clients view our industry, I decided to kick the discussion along.
I share with Robbie a growing anxiety about how we currently deal with financial risk. In addition, I suspect we have little understanding of what thought processes brought victims to their investment.
The failures of Westpoint, Fincorp and, most recently, ACR, which I presume are the drivers of Robbie’s concerns, illustrate a number of problems.
1. The risk inherent in the offerings were not adequately conveyed to intending investors.
2. In many cases, the offer was made directly to the potential investor, often heavily advertised on radio stations with older demographics.
3. In many cases, there was no independent research available.
4. The targeted market tended to be the most vulnerable: older investors concerned about earning sufficient income to fund their retirement.
5. Most traditional asset allocation models do not take into consideration allocations to direct property, private equity and/or alternative investments, so there is no guideline as to appropriate allocations for these investments.
6. There is considerable confusion about what products are regulated by the Australian Securities and Investments Commission (ASIC) and the labels that are put on products.
7. Many actual investors did not have the financial resources to cope with the loss.
8. Many actual investors were traumatised psychologically by the financial loss.
9. Many actual investors were overexposed to a single asset class and/or in most cases a single product supplier; that is, they had not built a properly diversified portfolio for themselves.
I have no special insight other than what I see in the general press. What I read suggests there are hundreds of investors waiting to find out what their investments are now worth.
Other than a small number of investments in Westpoint through financial planners, it seems the decision to invest in most cases was made by investors alone.
In respect of the first problem, a number of issues immediately come to mind:
> What legal documentation was required under law/regulations and was this documentation provided?
> Were the descriptions of the investment risks in the Product Disclosure Statements (PDS) understandable by a financially unsophisticated reader?
> Were those descriptions consistent with ASIC policy?
> Is ASIC adequately funded and does it have sufficiently trained staff to review, monitor and act in a timely way to protect consumers?
The courts will review these issues in the coming months (and probably years), and if there are any issues legislative change will undoubtedly ensue.
Many investors did not have the financial resources to cope with their loss
This is really an issue of ‘risk capacity’. A practical definition is ‘the ability to sustain a less favourable financial outcome from an investment without derailing the original goals and strategies’.
A potential investor should ask: Am I investing more than I can afford to lose?
This, of course, presupposes that the investor recognises there is risk inherent in all investments and perhaps more risk in ones that promise to pay higher than ‘normal’ interest rates.
Perhaps all direct investors should be asked to sign off a question built around risk capacity in their applications for an investment. At least this would achieve the twin aims of warning the investor while providing some level of liability shifting to the investor.
However, until investors actually read the documents they sign and understand the implications their signatures will mean very little.
Many investors were traumatised psychologically by their financial loss
Trauma results from being outside one’s risk comfort zone. A financial planner might use the term ‘financial risk tolerance’, which is ‘the extent to which an individual chooses to risk experiencing a less favourable outcome in the pursuit of a more favourable one’.
Whilst a scientific risk tolerance test does engage with the psychological consequences of being outside one’s comfort zone, we must not overestimate its predictive power.
Such testing merely suggests a greater likelihood of discomfort for those with a low risk tolerance than those with a higher risk tolerance from financial pain. We do know that everyone dislikes losing money, and for some the emotional trauma might be more than they can easily live with.
Knowing their financial risk tolerance and how it compares to others is probably a useful insight for all investors, but more so for self-directed investors.
There might be some merit in requiring all direct investors to assess their financial risk tolerance and sign off on their applications for investment that they might be accepting risks they could find difficult to cope with if things turn sour.
Once again, this would achieve the twin aims of warning the client and sheeting home to them some responsibility for their actions. However, they again must take the responsibility for reading and understanding what they are signing.
Many investors left themselves overexposed to a single asset class
While this would seem clear to those accustomed to using diversification as a risk management tool, there are some challenges in this notion.
It is not hard to see in the case of unsecured mortgage funds that too much money in any one investment is very risky. But as we extend the argument we find some quite uncomfortable positions:
> a large number of Australians have most of their assets in their family home and a residential property or two. Will residential property investors have to sign off too? And, of course, direct property is not regulated by ASIC;
> traditional portfolios tend to move to high equity exposure when targeting higher returns; and
> gearing requires exposure to the likely highest performing asset class with the greatest tax efficiency. Chasing the benefits of tax deferral, capital gains tax management and franking credits invariably leads to a high exposure to Australian industrial stocks held for the longer term, with limited or no international exposure.
Clearly, the diversification discussion can become very complex and technical, but it does not need to be. As an industry, perhaps we need to provide better guidelines on what we mean by ‘diversification’ and be able to explain the risk management benefits of asset allocation in plain English for investors.
Investors must take responsibility for their actions
The main theme of Robbie’s argument I think is investors need to take a lot more responsibility for the financial consequences of their behaviour, even when they are being provided with financial advice. This can be achieved by explicitly signing off that they have knowingly taken on ‘concentration risk’.
I have little difficulty with the first premise. I have been arguing for a number of years that a financial plan from a planner should only proceed after a ‘properly informed commitment’ from the client.
Indeed, the international standard for personal financial planning (and the parallel draft Australian standard currently open for public comment) specify that a planner must have the competence to obtain the properly informed commitment of a client to any proposals.
The foundations of ‘properly informed commitment’ are, at least:
> clear articulation by the advice provider of any conflicts of interest in the advice;
> transparent disclosure of risks associated with the product; and
> clear and full explanation of all costs associated with the product, which may have to be simplified to ensure full disclosure is possible.
The client must also be sufficiently financially literate and prepared to take (at least some) responsibility for the financial outcomes of their plan. The challenges for planners in this are significant. Simply getting sign-off is not enough. If it gets to the ‘judge test’, verbose, confusing fluff and puff documentation will not save the planner or the Australian Financial Services Licensee.
Empowering self-directed investors to achieve a properly informed commitment is an even more challenging task than achieving it through good planning advice.
We should try to understand the decision process of the victims
Perhaps one of the most important questions that needs to be answered is: Why did these people, so obviously in need of good financial planning and portfolio construction advice, choose to go it alone? Why did they not seek financial planning advice first?
My understanding of consumer behaviour is that if there is any uncertainty about the goals of an advice provider, many potential clients will not take up that advice opportunity. I suspect that those individuals who chose to go it alone with Westpoint et al believed financial planners were not for them because they did not trust the planner’s intentions and they believed the cost of advice would be too high.
Of course, it’s easy for me to make these assertions. But deep down, wouldn’t we all really want to know why proper advice was not accessed?
My explanation (and I accept it is unproven) is commission and ‘ad valorem’ fees result in a value proposition that many potential customers reject. This limits not only the potential market for advice but also the influence financial planners have over clients’ decision making.
The benefits of financial planning
Helping individuals think more clearly and behave more responsibly with their money promises significant enhancement in their ability to define and navigate their life.
Without a doubt, there is an accelerating cycle of virtue generated by the improvement of an individual’s financial behaviour, with benefits including:
> a personal sense of wellbeing by having, at least, the financial part of their life under control;
> individuals and their families becoming better protected from the vicissitudes of life through savings and appropriate insurances;
> individuals and their families becoming more financially self-sufficient, needing lower levels of community support;
> better matching of financial products to individuals’ needs, leading to greater persistency and consequentially profitability for their manufacturers; and
> the creation of a national wealth pool that reduces the need for offshore borrowings and investment.
If these really are the benefits that come from universal confidence in the integrity of financial planning should it not be a priority to generate that confidence?
Subscriptions poured into Westpoint, Fincorp and ACR despite the planning community’s widespread knowledge that they offered highly leveraged property plays that mismatched the needs of their typical investors. We knew, but they never even thought to ask us.
Don’t we really need to find out why?
Paul Resnik is an industry commentator and co-founderof FinaMetrica. E-mail: paul@prcg.com.au.
