Graham Bentley: Why risk conversations need to be overhauled

By Graham Bentley

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Jun 19, 2019

Advisers must be unbiased and present all scenarios, allowing clients to potentially reassess their goals

The relatively innocuous term “capacity for loss” has recently caused some bluster on Twitter. Adviser Nick Lincoln wrote an article describing the term “intellectually bankrupt” and the effervescent Abraham Okusanya pitched in with: “The idea we should contemplate and plan for permanent irrecoverable loss is lunacy… that we should consider scenarios worse than the historical worst case for an asset class ludicrous.”

Now, I certainly have some issues with the nebulous notion of capacity for loss. However, considered discourse on risk and investor psychology can be hampered by a red mist that descends on some passionate financial planning advocates when others dare suggest alternative views. Adorned with second-hand market histories, a brush with statistics and a one-night stand with Keynes’ A Treatise on Probability, some “experts” take a revisionist view of markets that, in less capable hands, can present a distorted interpretation of the past to serve an ideological – if not commercial – purpose in the present.

Lincoln’s view is that goals come first – the plan drives the portfolio – and that is incontrovertible. He goes on to say risk comes with the territory.

However, certainty that the “equity-leaning” portfolio is the only viable solution for all is open to scrutiny. The plan may have to be redrawn.

If one defines risk as the likelihood a hazard will give rise to harm, to what extent does the lack of achievement of a client’s required outcome amount to harm?

An outcome and arrival date that are precise, with no margin for error, imply less certainty of delivery than those that are more vague – for example, where the outcome can be further managed over an extended period, as with retirement income.

But the measure of harm relates to the impact of not achieving the goal, not its likelihood: risk = likelihood x impact. Risk is meaningless without a consequence.

For example, the owner of a thatched property that has never burned down in 500 years will still buy fire insurance because the impact of the unlikely event would be catastrophic. However, the purchase of an expensive extended warranty to cover the (more likely) failure of a television may be less appealing if the consequence of its failure is simply to watch Netflix on a tablet.

So the question for the client is perhaps: “If we get to the point you want to realise your goal and there isn’t enough money to pay for it, how would you feel?”

If they’d be devastated, that must be accounted for in the resulting portfolio structure. But say their attitude is more “life goes on”, then do they have a high capacity for loss, or might you alternatively highlight that there is no point taking risks to achieve something of so little consequence?

Turning to the worthy use of historic data in persuading clients to commit to equities, while those markets have demonstrated an ability to rebound from troughs to levels beyond previous highs, the recovery period in real terms would on occasion have tested the patience of older clients. The mid-1970s falls around the world took several years to return to previous highs in nominal terms and, in the UK, required more than 10 years, net of inflation.

More recently, the FTSE All-Share index, even with dividends reinvested, has over the past 20 years returned less than 5 per cent per annum and a little over 2 per cent a year, net of inflation.

It can also be argued much of that performance has occurred since 2008 with an unusual following wind of quantitative easing. If those lower returns and inflation levels persist, a 30 per cent fall in value would take over 18 years to recover purchasing power of capital.

If you are in your 40s, accumulating capital and continually investing at those lower prices, that’s not necessarily a daunting prospect.

If you’re 65 and expecting to withdraw capital regularly, after-the-fact promises of recovery may sound somewhat hollow.

Whatever the behaviour of markets, at the heart of the capacity-for-loss issue is not volatility, nor the regulator or even the persuasiveness of the equity-committed adviser, but rather the communication of risk.

Bad practice is to take the “trust me, I’m a doctor” approach. Good practice is to frame both the hazards and the benefits in terms the patient/client can understand.

Studies on communication of medical risk note numeracy is a significant barrier to understanding. Only 25 per cent of the population could correctly identify one in 1,000 as being the equivalent of 0.1 per cent.

Very few understood that an intervention doubling the risk of a negative outcome from a course of treatment was entirely dependent on the base case – i.e. doubling the risk of a one in 1,000 chance simply translated as two in 1,000.

Graham Bentley is managing director of gbi2

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