Were you to track regulatory changes over time, you would see a clear direction of travel. Aligning your suitability processes with this direction can transform meeting the rules from a burden to a competitive advantage.

You do this by shifting your focus from the letter of the laws – what they say: the isolated boxes to tick; to their spirit – why they exist: to ensure good client outcomes.

A focus on the boxes to be ticked rather than the reasons the boxes exist can lead to laws being technically followed at the expense of meeting the very outputs the laws are there to produce.

The spirit of financial advisory regulations is clear: to protect clients from bad investments, from unscrupulous salesmen, and even from the clients themselves. They aim to increase a client’s comfort and confidence with investing – to arm them with a greater understanding of what they’re investing in, and why.

The letter of the regulations says you must account for a client’s risk tolerance, knowledge and experience, and so on. But that’s not really what the regulations are after. Because it’s perfectly possible to ‘account’ for these in a counterproductive way.

See also: All I want for Easter is the findings of the FCA’s thematic review

For example, in its 2011 guidance, the Financial Conduct Authority (FCA) stated that they’d ‘reviewed 11 risk-profiling tools and were concerned to find that nine tools had weaknesses which could, in certain circumstances, lead to flawed outputs.’ And in its 2023 MiFID II guidance, the European Securities and Markets Authority (ESMA) spelled out: ‘In assessing a client’s knowledge and experience, a firm should also avoid using overly broad questions with a yes/no type of answer and or a very broad tick-the-box self-assessment approach.’

It pays to ask why these guidelines exist. Shouldn’t the rules themselves be enough, without requiring separate guidelines on how to follow them? The regulators would not have bothered releasing additional guidelines if the ways the risk tolerance and knowledge and experience boxes were typically ticked were good enough. The problem wasn’t what was being done, it was the way in which it was being done.

This is arguably even more apparent in the way Mifid II guidance and the Consumer Duty rules have incorporated the requirement to account for client behaviours. For example, the need not only to tell a client something but to take reasonable steps to make sure they have actually understood it.

We see something similar too with the new Sustainability Disclosure Requirements and their guidance to tackle greenwashing.

See also: Advisers have rich opportunity to treat investors more like humans, not robots

Problems of a checklist-focused approach to suitability

It is undoubtedly tempting to believe that methodologically extracting each requirement from the lines of legislation and ensuring they’re covered in some way will add up to a clean bill of regulatory health. However, this decontextualised line-by-line approach has some practical pitfalls:

1. It encourages ineffective upfront loading – Confirming the right level of investment risk for a client prior to investing is non-negotiable. But that right level is subject to dynamic change. Understanding of both the client and how they interact with their investments naturally grows over time. Outputs also decay. Of the main elements of suitability, only risk tolerance is broadly stable across time. Trying to get everything out of the way as soon as possible is effective for a checklist, but counterproductive for a client outcome.
2. It hinders client understanding – A client’s understanding of what they’re investing in (and why) is not helped by haste or volume, or by the lack of a clear link between information requested and its ultimate importance for them.
3. It leaves advisers playing catch-up – A focus on the letter of the law can leave advisers feeling like they’re playing a constant game of catch-up: tweaking processes, and bolting-on additional steps to meet each new requirement. However, reacting to regulatory changes is less efficient than anticipating them. A focus on the spirit of the laws should ensure that regulatory requirements are met as a side-effect of following processes designed for other purposes.

Future-proofing your suitability processes

It could be argued that all talk of ‘spirit’ is a bit unscientific, and no defence against a regulatory judge. This would be wrong. It is far more dangerous to rely on blind box-ticking with evidence only of the answer, not the process, or the reason, or what the question was, or why it was being asked.

This isn’t about abandoning the checklists in favour of assuming that if a client is comfortable then all is well. It is simply about where to angle your attention. To see that the best suitability processes focus less on acquiring client knowledge for the purposes of ticking boxes, and much more on how we use this knowledge in coherent suitability frameworks that reflect an understanding of what truly matters to investors.

They were invigorated by an end to interest rate hikes at close of last year as the prospect of potential cuts down the line painted a positive outlook for risker assets. However, this return in confidence receded in January as investors re-evaluated their timeframe for rate cuts.

Institutional investors dropped their average exposure to equities by 0.2 percentage points to 51.6%, instead building up their cash allocation by 0.6 percentage points, which now makes up a fifth (20.5%) of their portfolios.

The companies that institutional investors were buying tended to be in defensive sectors rather than cyclical parts of the market, according to State Street’s head of macro strategy Michael Metcalfe.

See also: RSMR: Glass half full or half empty for 2024?

This cautious approach was also visible in the fixed income space, with investors seeking assets in developed and core sovereign bond markets.

Metcalfe said: “These behaviours highlight the dilemma which markets faced through much of 2023, namely that more robust economic news, may at times not be positive for risk appetite.”

Confidence among institutional investors may have fallen back in January, but it strengthened in the retail market. UK investors added £2bn to equity funds throughout the month – the eighth highest on record.

This article was written for our sister title Portfolio Adviser

We have often heard the saying “Nothing ventured, nothing gained”. This pithy saying captures the essence of investing – without risk, there is no reward. However, risk implies different things to different people.

While some perceive risk to be a permanent loss of capital, others consider the variability of returns as a measure of risk. Over time, we have developed metrics which help us quantify risk, so that it is understandable and communicable. In trying to do so, we have relied on mathematical models, borrowing ideas from different fields to develop and enrich the vocabulary of risk.

However, a fallout of this has been ever increasing complexity, resulting in a lack of clarity in the true understanding of what we are trying to communicate.

Statistically speaking, the variance of returns of an asset class, as measured by the standard deviation, has become synonymous with risk since being introduced by Harry Markowitz in his seminal work on Portfolio Selection in 1952.

Incidentally, the paper, which won him the Nobel Prize for Economics in 1990, has no mention of the word “risk” in describing his investment strategy. He simply identifies that variance of returns is an “undesirable thing” that investors try to minimise.

Fast forward to the present day, the concept is mathematically linked to the standard deviation – the greater the variance or the standard deviation around the average, the less the average return will signify about what the outcome is likely to be.

Ground-breaking as the theory was, matters of practicality played a very important role in the implementation of the measure. Markowitz assumed that that practitioners would have no difficulty estimating the inputs to the model—expected returns, variances, and the covariances among all the individual holdings or asset classes.

However, to estimate these inputs, practitioners need to rely heavily on historical data. Consider historical data before the great financial crisis of 2008 – estimating inputs like volatility depends on decisions as to whether we include or exclude data during the event. The outcome of this decision results in a significant variation in the estimates.

Another issue stems from the idea that the returns on each asset, or for that matter a security, can be described with only two numbers: expected return and variance. Dependence on just those two numbers is appropriate if, and only if, security returns are normally distributed like the Bell curve, as described by Gauss.

Under such a distribution, no outliers are permitted, and the array of results on either side of the mean must be symmetrically distributed. When the data are not normally distributed, the variance may fail to reflect the full scope of the uncertainties in the portfolio. We come across this issue often.

Consider a simple example as in Figure 1 – it shows the distribution of monthly observed returns of the Dow Jones Industrial Average against the NASDAQ Composite Index. As all practitioners are aware, the Dow is composed of 30 of the most analysed and followed stocks, while the NASDAQ contains stocks of high growth, smaller companies. A quick inspection of the two distributions informs us that none of the distributions have the typical symmetric characteristics of the bell curve.

Figure 1: Distribution of Monthly Returns of Dow Jones Industrial Average Index and Nasdaq Composite Index

Source: Dynamic Planner

However, the Dow is a closer approximation than the Nasdaq index, which has much larger left tails, signifying a greater probability of large negative performance than the Dow. Thus, using a measure which relies on a symmetric distribution does not do justice to the risks posed by holding such an asset. This issue gets exacerbated as we delve into thinly traded stocks – as the example in Figure 2, which are the distributions of Google and DMC Global, a well-known Large Cap and Small Cap stock.

Figure 2: Distributions of monthly returns of Google and DMC Global

Source: Dynamic Planner

As can be seen, DMC Global has a bigger variation of returns along with a greater probability of large negative returns in comparison to the returns of Google. The second example provides an insight into the nature of instruments and their range of the prices.

Nevertheless, volatility, or variance, has an intuitive appeal as a proxy for risk. Statistical analysis confirms what intuition suggests: most of the time, an increase in volatility is associated with a decline in the price of the asset. Moreover, intuition and experience tell us that uncertainty should be associated with something whose value jumps around a lot over a wide range.

Yet there is no strong agreement on what causes volatility to fluctuate or even on what causes it in the first place. The only thing certain about volatility is that it sets in when the unexpected happens. But that is of no help, because, by definition, nobody knows how to predict the unexpected. On the other hand, not everyone worries about volatility. Even though risk means that more things can happen than will happen—a definition that captures the idea of volatility—that statement specifies no time dimension.

Once we introduce the element of time, the linkage between risk and volatility begins to diminish. Time changes risk in many ways, not just in its relation to volatility, which leads us on to various other measures of risk.

While volatility remains the preferred measure of risk, delving into its mechanics and nuances can help us navigate uncertainty with a degree of comfort.

This article was written for International Adviser by Abhi Chatterjee, chief investment strategist at Dynamic Planner.

Possibly buoyed by recent strong market returns, the survey showed one-in-four investors (26%) plan to use more of their £20,000 ($24,642, €22,704) Isa allowance compared with last year, with 5% of those asked saying their risk tolerance has increased “dramatically”.

According to Dragon Capital, the investment manager for Vietnam Enterprise Investments Limited (VEIL), the average UK retail investor will have used £5,649 of their stocks and shares Isa allowance in the 2022/23 tax year, rising to an average £6,537 amongst those with a stocks and shares Isa or Sipp.

“Stock markets around the world have experienced a significant rally in recent months and it appears to have given retail investors in the UK the confidence to take on more risk,” said Dien Vu, portfolio manager of VEIL.

“Despite the ongoing tough economic climate, it’s encouraging to see that many retail investors will have invested more in their ISA and Sipp this year compared with the year before, although it’s clear that the cost-of-living crisis is hampering the ability for a significant proportion to invest as much as they’d hoped to,” he added.

According to the research, about one in six (16%) of those UK retail investors polled said they will have invested less in their stocks and shares Isa or Sipp in the current tax year compared with the last, investing an average of £3,833 less. Some 70% blamed the cost-of-living crisis as the main reason.

For those investors less convinced about the recent rally and still worried about volatile markets following the recent banking collapses in the US and Europe, Jason Hollands, managing director of Bestinvest, recommended investors “dash for cash” to secure their Isa allowance.

“Private investors may feel they are facing a conundrum as to whether it is a good time to be investing in a stocks and shares Isa at the moment, and where to invest their Isa, but in reality, current market turbulence should not determine whether they take up their Isa allowances,” he said. “Isas are a precious annual tax allowance available on a ‘use it or lose it’ basis with the value of their tax-free status building over time as the savings and investments within them grow.”

For those unsure of where to invest, or are nervous about investing in the current climate, Holland’s advice is just to secure the Isa account initially with cash, and to decide where and when to invest it later.

“It is often the case that investing during periods of market turmoil and when the headlines are worrying prove rewarding over the long-term – but it never feels comfortable at the time,” he said.

“Hindsight is a wonderful thing,” he added. “A sensible approach to investing in periods of uncertainty is to funnel your cash into your chosen investments in stages to help iron out the effect of short-term market gyrations. This is an option open to those who secure their current year allowance with cash.”

This expectation comes as worries grow among advisers (67%) that they will be under pressure to pay compensation to clients whom they didn’t do enough to understand their risk suitability.

The Oxford Risk survey of 150 wealth managers in the UK, France, Italy, Spain, and Ireland, also found just 9% don’t believe they won’t come under pressure to pay compensation where they didn’t do enough to understand clients’ risk suitability.

This is surprising given that an overwhelming 67% of advisers surveyed previously still rely mainly on their own intuition to assess their clients’ risk suitability.

Some 53% believe regulators provide enough behavioural finance guidance on understanding clients’ risk suitability. In addition, 16% strongly agree, 26% are neutral on the issue, and 5% disagree with this view.

Greg Davies, head of behavioural finance at Oxford Risk, said: “Managing the investor is just as, if not more, important as managing their investments if the best outcomes are to be secured.

“Suitability – ensuring that investment solutions are right for individual clients’ circumstances and preferences – is the all-important concept in investment advice and a big part of this is having a detailed understanding of each client’s financial personality.

“An increasing number of wealth managers are alert to this but aren’t necessarily equipped with the right tools or training. Whether this is best achieved through increased regulation is still up for debate, but ultimately getting this right will not only have a huge positive impact on clients, but also on advisers themselves.”