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.