Good advisory businesses build their professionalism, protect themselves and ensure their businesses meet best practices by rigorously seeking to apply five proofs to their client advice process.
They:
1. Prove they know their client, their current situation, aspirations, risk tolerance and risk capacity.
2. Prove they have explored the range of alternative plans and strategies with the client.
3. Prove they know the products that they have selected to implement the client's strategy.
4. Prove that they have explained the risks in the strategy and the products to the client, particularly establishing performance and downside expectations.
5. Prove they received the client's informed consent to accept those risks in pursuit of their goals.
1. Prove you know the client, their circumstances, needs, aspirations, risk tolerance and risk capacity.
You need to have a good understanding of client assets and liabilities. This includes a good understanding of present and future cash flow. Best practice tells us that you should be able to illustrate this to clients with words, numbers and pictures.
Critically important here is the client's risk capacity. You must determine how much your client and any partner could afford to lose without messing up their present and future life plans. This usually means stress testing the client's balance sheet, particularly their investments and then reviewing future spending to assess when the client will run out of money.
You need to have a robust understanding of your clients' financial risk tolerance so that you can assist them take that into account in their financial plan. A useful definition of risk tolerance is "the level of risk an individual would accept in their financial affairs if goal achievement was not an issue." For couples acting jointly, the risk tolerance of each is relevant.
This approach is quite contrary to some risk profiling or "portfolio picker" tools, which are often no more than a few questions designed to meet regulatory obligations with a minimum of fuss and generate an investment recommendation.
Their outcome conflates risk required, risk tolerance and risk capacity into a score which has the same credibility as astrology.
More often than not, couples are assessed as one entity, merging any differences they have into one without any opportunity for advisory and client exploration. The score then converts to an investor description such as "you are a conservative investor who appreciates capital security and a steady and reliable income" and suggests a portfolio mix to do so. Consequently the risk is that the advice ignores personal circumstances, lifestyle needs, longevity and emotional needs.
Because this is so obviously nonsense, many advisors undertake such a process just to make their files look tidy. Often they then ignore the outcome altogether. The whole empty exercise becomes a mere lip service to good practice. This often leads to advisor-centric advice where the risk tolerance of the advisor is projected on to the client. Professional advisors usually manage to avoid this problem and get the right portfolio for the client but inexperienced or poorly trained ones often get this horribly wrong. The current dissatisfaction of many clients with their portfolios is testimony to this failure. It is not unreasonable for clients to be unhappy but they should not be overly surprised by the current state of the markets. Professional advisors explain downside risk and link it to their client's risk tolerance.
2. Prove you have explored the range of alternative plans and strategies with the client.
These strategies may include the need to work longer and harder, spend differently, change jobs or perhaps set up a business. The overall goal is to improve the client's lifetime cash flow position.
The advice will look at whether to spend more or save more. The goal is to allocate spending between now and the future on a rational basis.
The advisor can then determine the level of financial risk that the family is prepared to accept in pursuit of its goals. Generally risk is translated through to the amount and type of risky assets such as shares and property held compared to safe assets such as cash in the bank. Some may choose to hold more non-risky assets even though they might have less chance of achieving their future goals. Critical here is both an education of the client - illustrating what can be lost - and an understanding by the client of the impact on their plans if that loss occurs.
This is an iterative process, most clients have neither unlimited time and nor unlimited money and therefore the advice process eventually results in the establishment of a series of life goals, their prioritization and the activities and timetable to their achievement.
3. Prove you know the products that you have selected to meet the client's strategy.
Once you have decided on the strategy and relevant products you need to understand those products so you can argue that they appropriately meet your client's needs.
You may use external research to assist you make those decisions but the advisor is responsible for the final recommendation. The key issue, revealed by the current global melt down, is to understand how the product or service will behave when the markets fluctuate. Many products work well in good times but have a history of failing in bad times. A good understanding of economic history is needed when stress-testing products.
A word or two here about understanding products. One problem that advisors have had is fitting 'Alternative' Investments, Hedge Funds and Structured Products into a traditional portfolio construction methodology.
The answer, of course, is that you cannot do so. Let's look at why.
The traditional asset allocation process assumes the classic assets of Equities, Bonds, Property and Fixed Interest. Whilst there will be volatility, it is difficult for a collective fund of any one or combination of these assets to go to zero value.
The minute you add financial engineering, be it gearing, derivatives or securitization, you change the character of the asset. In short, with some, the value can - sometimes very quickly - go to zero or become negative in the case of gearing.
And that's the other part of risk. Risk is made up of both probability and impact. Most advisors look at volatility over time as a proxy for the probability of certain outcomes and use stochastic modelling to explore the likelihood of various outcomes.
For individual clients, however, impact is important. That is, not only are they concerned how likely a result is, but are also concerned as to how bad it could be. Only by understanding that certain products can and do go to zero value or worse can clients give anything like informed consent to these investments.
And the reason this argument is in this section, and not the next is that we would strongly suggest, with all due respect, that many advisers do not really understand this fundamental aspect of some products. We know this by the number of advisers who have their own assets and those of their Family in the likes of Arch Cru, Shepherds, Keydata et al.
In short, as advisers, do we fully and completely understand the products ourselves? Can we give informed consent?
4. Prove that you have explained the risks in the strategy and the products to the client.
As well as illustrating the more probable outcomes you need to explore the worst possible cases. You must be able to illustrate extreme events and explore clients' risk capacities. You must be able to show the consistency of the financial plan with the client's risk tolerance. You must have established processes for setting performance expectations and for ongoing management.
Obtaining the client's informed consent is an ongoing responsibility. This lies at the heart of the value of the relationship, but is not always understood by the advisor.
Ongoing informed consent is about ensuring that the advisor continues to understand not just risk tolerance - which is relatively stable - but risk perception, which can change in a heartbeat, and risk required, which can change in time, and risk capacity, which is important and variable.
The ongoing relationship helps to manage these possibly contradictory aspects of risk.
5. Prove you received the client's properly informed consent to accept those risks in pursuit of their goals.
Informed consent again! Having illustrated the client's balance sheet over time, and having taken into account extreme events and the client's financial capacity to cope, you need explicit instructions to proceed and confirmation that the client has given their informed consent to the plan and accepted the inherent risks.
This should not be confused with 'cover your a**' compliance activity. The purpose is not to defend you and your PI cover, but the purpose is to enter into a long term, 'win - win' adult relationship with clients.
Summary - The Overall Objective
Advisory businesses that have a reliable methodology for establishing clear client expectations and meeting those expectations will continue to grow their businesses in trying times.
This may well be at the expense of those that rely on investment outperformance as their primary offer. Clients and those that refer clients to an advisory business need to be confident that the advisory business will be there in both the good times and the bad.
Emphasis on investment returns only is an indicator that the firm may not be there for the troubles ahead. Evidence of a robust advisory process and evidence of a high level of client persistency will indicate a higher eventual value to the business, but, more importantly, a better overall client experience.
So, the challenge to advisors is: Does your process deliver the five proofs?
Geoff Davey, co-founder of FinaMetrica, has an international reputation for expertise in risk tolerance and its role in the financial planning process. A pioneer of financial planning in his native Australia, Davey has been a part of the financial services industry for 37 years. He can be reached via FinaMetrica's information portal, www.riskprofiling.com.