One of the most enduring narratives within financial advice is the question of value – what is the real value of financial advice?
Various individuals and groups have attempted to answer this question, each in their own way. Some have focused on the quantitative benefits that result from saving tax or maximising Centrelink entitlements. Others talk about the emotional benefits that accrue when one has a sense of control over their lives. And there are those who are able to bridge the two concepts, and attach a quantified benefit to emotions and behaviours.
Both Vanguard and Russell fall into this latter camp, each conducting research that allowed them to calculate the performance gains that result when the adviser mentors/coaches the clients out of bad financial behaviours. (Russell’s 2023 Value of an Advisor Report estimated behavioural coaching by financial advisers could improve the performance of client’s portfolios by as much as 3.4% per annum[1].)
But whilst this may be true, it begs the question whether more could be done earlier in the advice process, to build client plans and portfolios in a way that was inherently more resilient and less susceptible to poor client decisions and behaviours?
This article will explore the idea that the traditional, textbook ways of assessing clients’ risk profiles – building portfolios around those profiles – are flawed, as they ignore the realities of human behaviour. It will propose that viewing risk through a more behavioural lens, and structuring client plans and portfolios around goals and values, will result in clients being more focused, and more resilient in the face of portfolio volatility.
Traditional risk profiling leads to unsuitable portfolios
Despite the assessment of a client’s risk profile being an obvious – compliant – step to undertake, historically the processes used to complete this assessment have proved problematic.
Indeed, 2015 data from FOS (from which AFCA was born) found that 70 percent of cases escalated through them were due to inadequate or incorrect risk profiling of clients[2]. And in most of the cases, the adviser is likely to be found to be at fault, with more recent AFCA data[3] suggesting roughly two thirds of their determinations relating to ‘know your client’ failures found in favour of the complainant.
One particular finding reinforcing that the biggest red flag for advisers is not the failure to complete a risk profiling or risk tolerance questionnaire (RTQ), but rather it is the inherent flaws in those questionnaires themselves, in terms of whether clients understand them and the extent to which they accurately reflect a client’s true attitude to risk.
A typical advice process involving a RTQ would see a client answer the questions and then be classified as having a certain risk tolerance (conservative, balanced, aggressive) on the basis of their answers.
That tolerance or profile would then be matched to an asset allocation (50/50, 80/20 and so on).
Even assuming the client had accurately answered the questions, this approach is problematic. Not because it is formulaic and ‘cookie cutter’ (which it is), but because it ignores the realities of human behaviour.
Humans don’t behave in the real world like they say they will in a questionnaire
In a nutshell, a client may indicate – via a risk tolerance questionnaire – that they could stand a 20% drop in their portfolio. But, when the rubber hits the road and they see portfolio losses of that magnitude – even unrealised ones – the fact is that many people suffer a significant, visceral reaction, sometimes so severe that no amount of coaching and mentoring by their adviser can avoid them reverting to bad behaviours and poor, value-destroying decisions.
What drives our money emotions and behaviours?
Human beings are complex, emotional beings who are notoriously bad decision makers, especially when it comes to money and investing. Indeed, JP Morgan data for the 2001 – 2020 period found the average US investor achieved an average annual return of just 2.9%, compared to the 7.5% pa achieved by the S&P 500 over the same period[4].
There are two key drivers of our financial decision making. One is that bundle of mental shortcuts and biases that help us make the thousands of decisions each day without falling into a heap in the corner. The other is our deeply ingrained money mindset, typically formed during our earliest experiences with money and finance and often shaped by our parents.
To continue reading and receive CPD points, view the original article on AdviserVoice’s website.
[1] https://www.professionalplanner.com.au/2023/09/adviser-value-worth-5-9-pc-in-2023-report/
[2] https://www.griffith.edu.au/__data/assets/pdf_file/0027/205749/investment-risk-profiling-hunt.pdf
[3] https://www.moneymanagement.com.au/news/financial-planning/less-one-three-chance-defending-know-your-client-complaint
[4] https://www.fool.com/the-ascent/buying-stocks/articles/is-stock-picking-worth-it-heres-why-i-stopped-doing-it/
