Globally recognised expert in applied decision science, behavioural finance, and financial wellbeing, as well as a specialist in both the theory and practice of risk profiling. He started the banking world’s first behavioural finance team as Head of Behavioural-Quant Finance at Barclays, which he built and led for a decade from 2006.
This is the second post in a series giving our response to the FCA’s Call for Input on how to apply behavioural finance to help people make engaged investment choices more comfortably and confidently, and what role regulations can play in helping that to happen.
The series highlights four broad areas where better application of behavioural-finance insights can lead to better investor outcomes.
This post covers aspects of suitability that, while their importance is acknowledged, are typically poorly executed.
The full series (additional links to be added later) is:
The ‘consumer investment market’, as the name suggests, is where investors are matched to investments. The advice industry exists to help investors make wiser choices in this market. The concept of ‘suitability’ is the heart of this match-matching. Advice is suitable when it makes (and can evidence!) a good match, and unsuitable when it doesn’t (and cannot).
The regulations exist to control the environment in which advice is given, to encourage it to be motivated by more than the fee that can be charged for it (and of course to judge whether these encouragements have been attended to).
In its call for input, the FCA asked: What do you think are the main causes of unsuitable financial advice, e.g. weak competition, complex products, etc.?
While concerns such as competition and complexity are undoubtedly important, there’s a more fundamental answer: the basics of matching investors to investments still need more work.
There’s nothing inherently wrong with complex products… when they’re matched to investors that understand them. And stronger competition could simply mean more unsuitable products to choose from – as likely to increase investor confusion as reduce it.
In recent years, basic standards have been raised in several ways, including increased use of psychometrics to measure risk tolerance, attempts to measure risk capacity with something more serious than jabbing a moistened finger in the air, and going from nothing to something with knowledge and experience assessments.
Recognition that investors are human has also increased, with behavioural finance on both conference and FCA agendas.
However, getting a grip on the basics is a far cry from mastering them. Suitability rests on:
The attraction of ever-more-efficient shiny new toys is understandable, but dangerous. Making a poor process more efficient can make it worse, not better, especially when the resilience of that process has yet to reach a necessary standard.
Below we take a look at the common shortcomings of five basic elements of suitability – places where problems have been recognised, but typical solutions are found wanting:
Risk tolerance is rightly a cornerstone of suitability. Yet many measurement approaches are permitted despite being demonstrably flawed when judged against the academic literature on risk attitudes and psychometric assessment.
We don’t believe regulators should mandate precisely how risk tolerance (or any other component of suitability) should be assessed. However, a lot more could be done to discourage practices for which there is abundant evidence of inadequacy.
The following examples highlight proven poor practices permitted by a dangerously loose interpretation of current regulations:
Ability to take investment risk is – or rather ought to be – divided into financial ability and emotional ability. The ignorance of the latter will be covered in the next post in this series.
The failings of the former fall into two broad categories:
We’ll look at integration failures in section 4 of this article.
Typical approaches to measuring ‘ability’ are prone to several common flaws:
In addition to these mistakes of omission, there are mistakes of commission:
The common problem of how advisors approach the notion of investment time horizons is emblematic of a wider tendency to focus on the letter, rather than the spirit, of regulation. Focusing on a single arbitrary time horizon is an easy tick in a compliance box (satisfying the letter of the law) but works against delivering a suitable investor outcome (the spirit of the law). Meet the spirit and you automatically meet the letter; the reverse is not true.
Further problems raised by inadequate approaches to financial ability, in terms of getting good advice to consumers, e.g. inconsistent terminology and usage, will be looked at later in this series.
The FCA asks: ‘How can we better ensure that those who have the financial resources to accept higher investment risk can do so if they choose, but in a way that ensures they understand the risk they are taking?’
In theory, this is what Knowledge and Experience (K&E) assessments are for. In practice, however, typical K&E assessments are not as much help as they should be.
All too often, K&E turns into an onerous, and largely pointless, box-ticking exercise where the investor is asked – at excruciating length – details of every investment type they’ve held, and how often they’ve traded them… despite neither being a particularly useful proxy for knowledge or experience.
To be effective in driving better decisions, and better investor outcomes, K&E assessments need to be more principles-based. Cumbersome checklists should be discouraged, not only because such approaches are useless, but because they run the risk of being actively harmful. They detract from the credibility of the advice process, and have the potentially perverse consequence of implying that an investor who had not previously traded in a particular instrument should exclude that from a sensible diversified portfolio because of lack of specific experience.
As with the drawbacks of ‘pot’ approaches to Risk Capacity, the focus should be on the suitability of the overall portfolio, rather than individual components. Unfamiliar assets can be highly valuable, or even necessary, in a robust diversified portfolio. This is another area where a focus on the letter, rather than the spirit, of the regulations, harms suitability.
Moreover, this feeds into the wider behavioural issue of relying on disclosure as a mechanism to drive better decisions. Disclosure has been proven time and again to be ineffective, or even off-putting – disengaging people when the very thing we’re trying to do is engage them. (See also: Disclosure Changes Everything by George Loewenstein, Cass Sunstein, and Russell Golman.)
Engaged choices are vital to helping investors understand their investment options. Simple disclosure, and even ‘nudges’ often fall short. There are more effective measures, for example just-in-time education. This runs counter to the tendency to front-load suitability assessments, but it fits in perfectly with a more dynamic approach to suitability as advocated above.
In the regulations, a consumer’s willingness and ability to take investment risk go hand-in-hand. In the world those regulations govern, however, there is a concerning failure to see the two as interrelated components of the same suitability system.
Often, Risk Capacity is the key determinant of the right level of risk for an investor to take right now. However, the lack of quantitative, dynamic, and holistic measurements of it mean that Risk Capacity is regularly and recklessly underweighted relative to Risk Tolerance in the calculation of the Suitable Risk Level for an investor.
If Risk Capacity isn’t reliably and consistently quantified, and changes to it in response to changing financial circumstances aren’t accounted for, it’s liable to get overlooked… especially if an investor’s looking through a narrow pot-based lens.
The lack of consistent quantification gives rise to a further issue: when measurements of Risk Tolerance and Risk Capacity don’t speak the same language, it’s impossible to combine them with anything approaching an adequately scientific methodology. A subjective human-led process for assessing and combining the myriad parts of a full assessment of financial circumstances (a necessity absent such a methodology) leads to huge amounts of both bias and noise in advisory processes.
The over-reliance on Risk Tolerance renders suitability much less dynamic – and the Suitable Risk Level much less responsive – than it should be. Doing it right rests on a reliable and responsive means of assessing Risk Capacity that’s neither based on subjective assumptions nor overfitted to initial circumstances.
Having determined the risk each investor is willing and able to take – in, we hope, a behaviourally conscious and scientifically robust way – the final link in the suitability chain is matching each investor’s risk to the universe of available investments.
On the surface, suitability is simple. Profile an investor, map that profile to a portfolio and check in periodically. Yet few ‘solutions’ offer any credible means of accomplishing this. At Oxford Risk we have developed a methodology for making this link which we believe to be unique in both its reliability and its accuracy.
Each of these failings of existing suitability can be traced to favouring short-term expediency over long-term regulatory resilience. The regulations as they stand unwittingly encourage these myopic mistakes.
These gaps are many, and may seem daunting to close, but each and every one of them is closed, thoroughly and consistently, in Oxford Risk’s Suitability Compass.
The spirit of suitability regulations is better consumer outcomes: better matching of investors to investments; and more investor comfort, confidence, and understanding along their investment journeys.
This calls for dynamic suitability: a process that accurately reflects the development of each human investor’s overall circumstances and personality, rather than one that overemphasises the importance of their initial position, and over-relies on noisy subjective judgments.
In the long-run, focusing on the ‘efficient’ ticking-off of regulatory requirements in isolation serves neither institutions, nor investors. It’s not good for institutions, which have to keep revisiting their increasingly Frankensteinian processes. And it’s not good for investors, who want to understand, and to be understood, but who are left feeling uneducated and unengaged.
Chasing shiny new toys leads to forever playing catch-up.