How can a financial adviser give good long-term investment advice to a client who is risk averse?

@Brendan Burgess Brendan, I accept your decision to edit my posts questioning posters' motivations for continually doubting the reasonableness of my approach. However, I think it's worth asking for views - probably in a separate thread - on the challenge for financial/ pension advisers, aside from 'housekeeping' matters, such as questions on tax relief, quality of service from different institutions, etc. For example, is there any truth in my assertion earlier in this thread that one of the adviser's biggest challenges is to persuade clients to overcome their natural loss aversion, and invest in so-called 'risky' but hopefully higher-return assets if they have a long investment horizon. At least that is what one adviser, who is quite active on this site and for whom I have a lot of respect, once told me. Some other advisers apparently don't share his perspective and seem to be even more risk averse than their clients. I wonder if that is due to the phenomenon I mentioned earlier in this thread, that their risk-return payoff is quite different from that of their clients: they are in trouble with the client if the investment they recommend goes down in value, but the client is likely to give themselves part (at least!) of the credit if its value increases. That risk-return payoff would make me think twice about recommending so-called 'risky' investments if I were a financial adviser. How does the good adviser overcome it?

Hi Colm
Good question. I have moved it to a new thread. Feel free to edit the title, if it does not summarise your point correctly.

Brendan

I was very surprised by this comment by Marc in the other thread.

Marc said:

one might be willing to assume a high degree of investment risk (risk tolerance) but objectively what matters most and certainly from a regulatory perspective is an objective assessment of one’s ability to bear losses (risk capacity) many people will find with the benefit of hindsight that buying an annuity at outset may well have been a better decision.

In court any financial professional who was found to have “advised” their clients to pursue such a, from a fiduciary perspective, reckless approach, would be Judged by international standards of jurisprudence which ordinarily demand of professional advisers a more diversified investment strategy. Colm, a retired Actuary should be aware of this legal fact.

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I think it's reasonable for Marc and me to disagree on investment strategy. I respect his views, even if I disagree with them.

Have a look at that thread, and there are well informed people arriving at opposite conclusions.

Imagine if I advised someone to invest 100% in equities at aged 65 and there was a sustained fall over the next 5 years. They ditch me as an advisor and go to Marc. Marc says that my advice was negligent. And the client sues me.

How could a judge make an informed decision? Experts on both sides would come to different conclusions.

It probably would be much safer to say invest 50% in equities and 50% in bonds. Or buy an annuity. If inflation wipes out the annuity, I doubt you could sue the advisor.

There used to be an expression "No IT manager ever got fired for choosing IBM." It's a bit like that.

Brendan

@Brendan Burgess

For the avoidance of doubt I did not say at any point in the thread referred to that I was conservative, risk adverse or against having an equity bias over the long term. Quite the opposite, I genuinely believe that many investors are, to use a phrase coined during a systematic investigation by HM Treasury in the UK, "recklessly conservative"

Exhibit A


Clearly an equity biased portfolio makes sense over the long term but as Keynes said; "in the long run we are all dead"


My specific issue is with the casual way in which a 100% equity portfolio (which it turns out is just 12 stocks which is frankly insane) is promoted by yourself and others as suitable and appropriate for the lay investor and specifically in the context of a post retirement income portfolio.

For many investors a 100% equity portfolio is objectively imprudent as they simply lack the capacity for loss

example

Let’s say that 5 investor's each have an objective of an annual gross return of €20,000pa





Each investor has exactly the same income objective, but the investment risk associated with this objective is directly related to their starting capital. It has nothing to do with their risk tolerance or willingness to take the required risk to achieve the objective. It is simply a mathematical fact that someone with €5m needs to take less investment risk in order to achieve the same investment income as someone with less money.


So, whilst it might be ok for you and others to take on a 100% equity portfolio so that a 50% drop might leave you with say €500 grand. You might be badly bruised but you can probably survive.

Its not acceptable to take that personal perspective and apply it to the population at large when providing financial advice. Your sample of one is virtually irrelevant. You might be lucky, but luck isn't a good investment strategy or we would all just go to Vegas!

How risky is the market?

I went to great lengths to spell this out in the thread and there is over 100 years of data in the attached guide.

Here is an example

By way of an example using the US Market for the period January 1929 to December 1938

The annualised return of the US Market over this period was -0.89%pa a total return of -8.52%

However, the cumulative return to the end of 1932 was -64.22% that's losing 22.66%pa for 4 years.

That means a million invested at the start of 1929 was worth around 360,000 by the end of 1932!!

You would need a return of 278% just to get back to where you started just 4 years earlier.


How risky are individual stocks?

A very poorly diversified collection of just 12 Stocks is even more risky than the market since any individual company can, and frequently does, go to ZERO value.

[broken link removed]


What view do the courts take?

For many years we have been guided by the test of the man or woman on the Clapham Omnibus, established in the Court of Appeal, re Whiteley 1886

“as an ordinary prudent man would take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide”

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This has been further evolved over the years in many countries and in some cases legislation has been written to enforce prudence.
For example the Prudent Investment Rule 1992 in the USA states

1. Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
2. Risk and return are so directly related that trustees have a duty to analyse and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
3. Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by the needs and realistic objectives of the trust’s investment program.
4. The fiduciary duty of impartiality requires a balancing of the elements of return between production of current income and the protection of purchasing power.
5. Trustees may have a duty as well as the authority to delegate as prudent investors would.

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“Restatement of the Law, Trust, Prudent Investor Rule” published in the USA in 1992

So, the subject of this thread now seems to have changed from "what is wrong with a 100% equity portfolio?" to "how do you advise a conservative saver to invest some of their money?"

talk about two ends of the spectrum!

So back to exhibit A


appropriate benchmarking

An important factor when considering how successful an investment adviser has been at getting a client to follow and act upon prudent advice is to assign a risk appropriate benchmark for comparison purposes.

The goal of a client will never be to track a random index such as the Dow Jones or to make the highest return in an annual Micky measuring contest.

Prudent investors in retirement work out how much they need to support their lifestyle and therefore how much income their portfolio needs to generate, their adviser then works out what portfolio has that expected return and benchmarks their performance to the annual required return of the client rather than some arbitrary benchmark or the increasingly common approach of ESMA risk bands


Using this approach means that the painting by numbers risk profile approach


is thrown out and replaced by a more appropriate client-centric advice process.


“Ignorance more frequently begets confidence than does knowledge: it is those who know little, and not those who know much, who so positively assert that this or that problem will never be solved by science.” Charles Darwin

Colm Fagan said:

@Brendan Burgess Brendan, I accept your decision to edit my posts questioning posters' motivations for continually doubting the reasonableness of my approach. However, I think it's worth asking for views - probably in a separate thread - on the challenge for financial/ pension advisers, aside from 'housekeeping' matters, such as questions on tax relief, quality of service from different institutions, etc. For example, is there any truth in my assertion earlier in this thread that one of the adviser's biggest challenges is to persuade clients to overcome their natural loss aversion, and invest in so-called 'risky' but hopefully higher-return assets if they have a long investment horizon. At least that is what one adviser, who is quite active on this site and for whom I have a lot of respect, once told me. Some other advisers apparently don't share his perspective and seem to be even more risk averse than their clients. I wonder if that is due to the phenomenon I mentioned earlier in this thread, that their risk-return payoff is quite different from that of their clients: they are in trouble with the client if the investment they recommend goes down in value, but the client is likely to give themselves part (at least!) of the credit if its value increases. That risk-return payoff would make me think twice about recommending so-called 'risky' investments if I were a financial adviser. How does the good adviser overcome it?

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I haven't been keeping up with the original thread due to having to do the day job and then seeing it is now on page 7 and a lot of reading is required to get up to speed. So thank you Brendan for making a brand new thread!

The problem Colm is advisors not getting an understanding of what a client's perception of risk is. I always ask a client what they think investment risk is. The majority say losing all their money and not getting it back. Once you explain to them that this doesn't really happen (although I spoke to someone yesterday who has been "advised" to release equity in his home and business premises and invest it in ventures that went bust. He now can't retire because of the levels of debt he still has) and that what the industry calls risky is investing in the likes of Apple, Microsoft etc they are more comfortable. But that does not mean that your money is safe, indexes have fallen by -45% in the past, even with the big companies in it. It's just they have come back.

I do get people referring to what happened to Bank of Ireland and AIB, the "blue chip" stocks and I have to explain that they were never blue chip and were always actually higher risk, smaller companies that should have never been described as blue chip.

I agree with Marc on capacity for loss and it is something that I always go through with clients, showing them the value of their money in past crashes (% falls don't have the same impact of saying "Your €1m ARF would be worth €585,000 if an equivalent crash happened yesterday".

A lot of investment advice these days is automated and driven from the results of a flawed, risk profiling questionnaire that the client completes and the life company produces an instant recommendation and report off the back of it that is white labelled with the advisors logo. They don't take the client's actually wants and needs into account.

But to be honest, I don't have any issue with clients being invested in equities but none of my ARF clients are 100% equities.

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

Possibly because it may not be in the best interest of their clients.

The stock market has performed well in recent years since the financial crisis, but past performance does not guarantee future performance. If you are accepting risky assets in retirement to achieve your required level of income then you are living beyond your means in my opinion. This is no different in my opinion to the advice given to posters on this forum who are carrying a large amount of mortgage and or personal debt.

The number of PRSA/Pension (pre/post retirement) applications I'd see, on an 'execution only' basis, with 100% equity only fund selections would be very small. So, no adviser input. And, even at that, it's likely that those clients may not be relying on a pension product as their only retirement asset or that the decison on risk/fund may have been made by a couple who will rely on the income from it.

That said, the (current) No. 1 fund (by AUM) on my main agency would have an indicative equity range of 75%/100% - mixed fund with balance in bonds/cash.

Gerard

www.prsa.ie

@Brendan Burgess I don't think the title adequately reflects how I would like the discussion to develop. Maybe something on the lines of "How can a financial adviser give good long-term investment advice to a client who is risk averse?" would be more appropriate.
I'll start the ball rolling. Because of my background in finance and my (supposed) knowledge of investments, family and friends sometimes ask me where they should invest their nest egg. My first (and second and last) inclination is to run a mile, because I know I'm on a hiding to nothing. There's no upside for me if whatever I advise does well, but my family member/ friend will think I'm either a fool or a knave if it does badly - which is always a possibility, even for the most carefully chosen investment. If I were forced to make a recommendation (which I have invariably managed to avoid up to now), I would probably try to find something with some potential upside but limited downside. I wouldn't touch one of those products with a barge pole for my own portfolio, because I know they have rotten payoffs, so I really would be a knave if I ended up recommending such a product to a friend!
I am interested to learn how professional advisers address the problem. I fear that some of them do precisely what I would do if forced into a corner. It's a sad lookout for clients if that's what happens in practice.

Hi Colm
I am in the same situation as you are. I am not a professional advisor but am sometimes asked by people where they should invest.

I give them a disclaimer first.
Then I set out the options and highlight that cash is not risk-free. If they are risk averse, they should be avoiding cash.

But they usually end up in Savings Certs anyway.

Oddly enough, even if they have a mortgage, they don't want to clear the mortgage first.



Brendan

Many advisers are on a “hiding to nothing” in this scenario. They know that if they recommend a particular strategy (even after interrogating the client as to their attitude to risk) and it works out, then the client is likely to claim some/most of the credit, but if it doesn’t work out then the advisor is fully to blame. So most will tend to favour a “middle of the road” strategy, thus ensuring that at least they won’t end up at the bottom of some league table. When it comes to a client “attitude to risk” , then I like Warren Buffet’s quote - “you only find out which swimmer is wearing trunks, when the tide goes out”. Most investors are happy to take risk when the markets are going up, but less happy to do so on the way down.

A financial advisor can only advise. It is individual decision as to level of investment risk. A financial advisor can do excellent job but client makes overly conservative decision.

Is the real question not the importance of population understanding what is investment risk, the different levels of risk , different types of risk. Example, I would guess a lot of people focus on risk of drop in value of investments but less focus on inflation. Is financial advisor expected to provide investment education course?

Brendan Burgess said:

Imagine if I advised someone to invest 100% in equities at aged 65 and there was a sustained fall over the next 5 years. They ditch me as an advisor and go to Marc. Marc says that my advice was negligent. And the client sues me.

How could a judge make an informed decision? Experts on both sides would come to different conclusions.

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Can you sue someone in Ireland for poor investment advice?

NoRegretsCoyote said:

Can you sue someone in Ireland for poor investment advice?

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You would need to show that they had been reckless or negligent.

"The term professional negligence relates to any industry in which a professional fails in his or her duty of care towards you. ... You can claim compensation for professional negligence if it can be proven that you have suffered a loss if the service you received was less than that which would be reasonably expected."

Colm Fagan said:

I'll start the ball rolling. Because of my background in finance and my (supposed) knowledge of investments, family and friends sometimes ask me where they should invest their nest egg. My first (and second and last) inclination is to run a mile, because I know I'm on a hiding to nothing. There's no upside for me if whatever I advise does well, but my family member/ friend will think I'm either a fool or a knave if it does badly - which is always a possibility, even for the most carefully chosen investment.

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Hi Colm,

I enjoy your posts but...…..

You've got me all confused! The gist of the above is that you want to avoid, at all costs, the game in which "eaten bread is soon forgotten" but when folk lose "bread" (readies), it's always remembered. I can get this!

What I'm struggling with is that if this is truly your first, second and last - why the dickens did you write the Investor Diary - as in surely there was a much easier way to achieve your supposed primary objective?! And why would you promote concentrated all-in equity portfolio for folks' retirement savings - sooner or later, people will pick the wrong concentration or equities generally will flounder? At such times, guess who will be remembered?!

Whilst I'm at it, I can't proclaim to have read every post in the other interesting thread - so apologies if this is inaccurate - but there seems to me 2 aspects of your ARF strategy that needs to be borne in mind by Joe or Josie Public. I have the impression, rightly or wrongly, that these points do not come across clearly in your posts.

1. Most folk will not be running their own equity portfolio - i.e. they will be investing in an equity fund of some type. Hence, they will not have dividend income. Hence again, even if the premise is accepted that dividends help with sequence risk, such protection will not apply as they will be obliged to sell equities at depressed levels.

2. The "tightening your belt" in tough times is well and good for affluent old actuaries - but Josie Public may have substantially less wiggle room.

Marc said:

You would need to show that they had been reckless or negligent.

"The term professional negligence relates to any industry in which a professional fails in his or her duty of care towards you. ... You can claim compensation for professional negligence if it can be proven that you have suffered a loss if the service you received was less than that which would be reasonably expected."

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Even still.

Well known firm in Dublin were advising clients to release equity in their homes and invest the money in products that ultimately failed and the clients were left with nothing but debt. The firm closed, those involved moved on and nothing happened.

Only reminded of this as I was contacted recently by someone who took their advice and is nearing retirement age, is on interest only loans on home and commercial mortgages. A total mess.

Conan said:

Most investors are happy to take risk when the markets are going up, but less happy to do so on the way down.

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No one ever rings me and complains that they are making too much money!

Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

FintanJ said:

A financial advisor can only advise. It is individual decision as to level of investment risk. A financial advisor can do excellent job but client makes overly conservative decision.

Is the real question not the importance of population understanding what is investment risk, the different levels of risk , different types of risk. Example, I would guess a lot of people focus on risk of drop in value of investments but less focus on inflation. Is financial advisor expected to provide investment education course?

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People need to understand where their money is. They don't have to understand the ins and outs of investing but they need to know what kind of companies they are invested in and what kind of bonds they have. Some people have a keen interest in it to others who just tell you to make the decision.

I liken it to me and cars. I drop my car into the mechanic to service. He could show me what he has done but I don't care. I pay him to make sure it's fixed and won't break down. Others will be under the hood with him.

As an advisor, we have a responsibility to take care with our clients money and that means avoiding unnecessary risk (I won't recommend anything with borrowing). Unfortunately, too many advisors are nothing but salesmen after large commissions and are more working for product providers than they are for the people they are supposed to advise.

And when things get bad and the value of their investments fall, communication is key. Talking to clients and letting them know what is going on and this was always going to happen at some stage, we just didn't know what it was going to look like.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)

SGWidow said:

What I'm struggling with is that if this is truly your first, second and last - why the dickens did you write the Investor Diary - as in surely there was a much easier way to achieve your supposed primary objective?!

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I don't get your point. I'm very happy to set out my own experience. I am not advising anyone to do as I did. In fact, I've told lots of stories of my investment disasters over the years, from which people will surely take the message that they could be far better off NOT doing as I've done! While I'm on the subject of recounting experiences, it would be great if some real life financial advisers could share (anonymously, of course) some of the (good and bad) experiences of their clients, so that we could learn from them. For example, I don't think there is anything available at market level, setting out what ARF investors have actually earned (after fees and commissions) over the last (say) 3, 5, 10 years. I've given the figures for my ARF. It would be lovely to hear from advisers the range of returns (net of all fees) earned by their clients.

I think I've told the story of the origins of my investor's diary already. Anyway, here it is again. After making a couple of disastrous investments, I concluded that I would not have made such cock-ups if I had written a little note to myself beforehand, setting out why I planned to buy that particular investment. I was writing those notes to myself for a while. Then I thought that other people might find them interesting, so I published them more widely. I was lucky to get the Sunday Times to run with them for a while, but that was just a bonus. Now what's your point about there being a "much easier way to achieve my supposed primary objective?" What do you think my primary objective is? (As an aside, writing about planned investments in advance didn't prevent me making more bad choices, but I do think it reduced their incidence).

SGWidow said:

And why would you promote concentrated all-in equity portfolio for folks' retirement savings - sooner or later, people will pick the wrong concentration or equities generally will flounder? At such times, guess who will be remembered?!

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As I've said many times, I am NOT advising others to do as I've done. I'm simply recounting my experience. You probably would have a point if I wrote exclusively about wonderful investment coups that I've pulled off, but I haven't. I've probably written more about poor investments than about good ones. If there is a lesson I want to impart more generally, it is that "real" investing is not about fluctuating prices of unit-linked funds. It's about putting my money in real businesses and leaving it there for a long time if possible.

SGWidow said:

Most folk will not be running their own equity portfolio - i.e. they will be investing in an equity fund of some type. Hence, they will not have dividend income. Hence again, even if the premise is accepted that dividends help with sequence risk, such protection will not apply as they will be obliged to sell equities at depressed levels.

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Yes, I have made those points numerous times, maybe not in this thread. It is also worth adding that people who don't run their own portfolios suffer much higher charges than I've incurred - and those charges are experienced at all levels. On this subject, there were some frightening revelations of high charges by advisers and insurance companies in today's and yesterday's "The Currency". Well worth reading.

SGWidow said:

The "tightening your belt" in tough times is well and good for affluent old actuaries - but Josie Public may have substantially less wiggle room.

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I agree with you on that. I think it was in this thread that I mentioned the contributor to the discussion on my January auto-enrolment paper who asserted that it was fine for affluent people like myself (and Seamus Creedon, who opened the discussion) to invest our money in expected-high-return equities, but that it was wrong to give the same advice to the less affluent, that they should be consigned instead to low-return bonds. The entire purpose of my auto-enrolment paper was to allow less affluent pension savers to enjoy the fruits of the higher returns from equities throughout their entire lives (including all through retirement) at volatility levels comparable to high-interest deposit accounts. I'm hoping that, eventually, the penny will drop that I am right and that the approach I'm advocating will be introduced. Based on what I've read in "The Currency" it cannot happen soon enough.

SGWidow said:

You've got me all confused!

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I hope that I've unconfused you!

I am not a professional financial advisor but my career was in financial services.
A couple of years back some ex colleagues of Zurich Life came to me for "advice" on their offer of an enhanced transfer value of their deferred pension. I cobbled together a spreadsheet to allow them play with the possibilities. Not surprisingly they all went for the ETV (money in the hand much more desirable than a pension which was guaranteed to be doubled (3% p.a.) in their 80s).
The next bit was where should they invest the money? They were being offered a choice of Zurich's Prisma funds risk rated from 2 to 7 at subsidised AMC. My first almost subconscious piece of advice was that there was no point in looking at alternative fund managers - the subsidised AMC trumped any spurious alpha differentiation.
Zurich gave an indication of the potential returns and volatility of the various risk rating choices and I accepted them at face value and fitted them to a lognormal model (@Marc ). I let them play with the spreadsheet to get a sense of what the various choices meant in terms of the Quartile distribution of future year by year pay-outs. They had a facility to input a one off fall in equity values which the spreadsheet converted to the impact on the chosen risk rated fund.
So in the round I saw myself as informing not advising and I note the following points:
1) Ex ante differentiation of fund managers is spurious except as regards their charges
2) It was not for me to persuade them to take risks they don't want to take - but merely to let them have a good sense of the risks
3) I carefully avoided conveying my own instinct that markets were in bubble territory - a view that I have had for as long as Colm has been cleaning up! But they are clued in enough themselves to have a broad awareness of stockmarkets and their recent performance and potential for "crash". I let them test their fears (though I admit the spreadsheet as shipped had a 30% one off fall as its input).
4) I didn't bother them at all with the annuity option. I suppose that is advice but considering they had accepted the ETV it would be silly to reverse back into a lesser annuity. I did give a facility to annuitise at older ages.

As a separate point each of my advisees would probably be thinking in terms of leaving the family home to their estate but not much else and they were aware that in switching from pension to ARF the possibility of "windfall" inheritances arose.
This highlights how important personal circumstances are. I suspect that Colm's "good luck" is really good luck for his kids. Does he consult them on his investment strategy? At the other end of the scale someone investing 100% in equities may be risking being unable to keep a car but in the expectation that if equities behave themselves they might be able to trade up from a Ford to a Tesla. Utility considerations are paramount in making these risk reward trade offs.

SGWidow said:

1. Most folk will not be running their own equity portfolio - i.e. they will be investing in an equity fund of some type. Hence, they will not have dividend income. Hence again, even if the premise is accepted that dividends help with sequence risk, such protection will not apply as they will be obliged to sell equities at depressed levels.

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I don't think that is entirely correct. Let's say the internal dividend earnings of the fund are 2.5%. These are reinvested. Now a 2.5% withdrawal is simply reversing that reinvestment. There are of course timing and other differences but the broad effect is similar to the dividends having been distributed. As a further thought one observes that a reinvesting fund is rather inefficient for people in the withdrawal phase.