More On Legal & Compliancefrom The Advisor's Professional Library
- Nothing but the Best Execution Along with the many other fiduciary obligations owed by RIAs, firms owe a duty to seek best execution of clients transactions. If they fail to do, RIAs violate Section 206 of the Investment Advisers Act.
- Code of Ethics Rule The Code of Ethics Rule, found in Rule 204A-1, uses severe consequences for violation to help ensure investment advisors will do the right thing.
It's one thing for clients to be unhappy about losing money and quite another to be unhappy about bad advice. No one enjoys losing money but the pain is doubled or tripled when the magnitude of the loss exceeds your worst nightmare, as it has recently for many clients. Many advisors are angst-ridden over this development, and for good reason.
In the interests of full disclosure, I cofounded a company that produces a risk tolerance assessment tool which I consider to be far superior to the industry-standard questionnaires. This argument is not about my company's product, but about many advisors' failure to accurately assess a client's risk tolerance and build portfolios that are consistent with that risk tolerance.
By and large, clients' risk tolerance has been dealt with inadequately, if at all, and explanations of downside risk have been misleadingly optimistic and/or opaque. Many clients have been following strategies at levels of risk well beyond their risk tolerance and did not understand the risks they were taking.
Unfortunately, our industry is bedevilled by the superficially plausible, of which there is no better example than the standard risk questionnaire. From a jumble of questions about time horizon, goals, investment experience, risk capacity, and risk tolerance, an asset allocation/model portfolio recommendation is extracted.
All too often in the process, risk tolerance is never specifically identified and there is no way of telling whether the resulting recommendation is consistent with it. But the attraction of getting to a sales proposition in a single step is very seductive, albeit unprofessional, unethical, and quite possibly illegal, given an advisor's duty of care.
Yet there is an established discipline, psychometrics, which allows for valid, reliable, and accurate assessment of risk tolerance in plain English. Psychometrics provides guidelines for test development and standards against which tests can be evaluated. Psychometric tests are used extensively in education, recruitment, and human resources. However, the financial services industry chooses to ignore the rigor of psychometrics and persists with risk questionnaires that have all the robustness of a tabloid quiz.
Nonetheless, surely advisors explained the risks in the portfolio strategies they recommended so that clients can't say they weren't warned, or can they?
Were current events within clients' range of expectations? From all reports it would appear not in most cases. Yet there are recent precedents. The current bear market is no worse than 1973-74 or 2000-02. In 1973-74 the S&P 500 fell by 43% (52% real, i.e., after inflation) and in 2000/02 it fell by 45% (47% real), whereas as of the end of February 2009, the current fall was 51% (52% real) from its high in 2007. Surely this was explained to clients? I think not.
Even when advisors try to explain downside risk, they usually fall back on statistics: averages, 95% confidence levels, frequency of negative one-year returns, and so forth. Clients find these difficult to understand (as do some advisors) and in any event they are falsely based on the assumption that returns are normally distributed, meaning that the possibility of extreme events is greatly underestimated. (For a more meaningful explanation of downside risk, download our Risk and Return Guide and Charts under Resources at www.riskprofiling.com.)
Some are using the advent of Black Swan Theory to provide a convenient excuse. But that is not an accurate analogy. To quote Harry Markowitz, "The 28.5% loss in 2008 in the S&P 500 is between a two- and a two-and-one-half sigma move...It is not a Black Swan, which is about eight standard deviations."
So where does that leave us? Clients have been blindsided twice in the last decade, which is at least once too many. Will we see a re-evaluation of processes used to deal with risk tolerance and explain risk?
One can only hope.
Cofounder and Director
FinaMetrica Pty. Limited