Applying Behavioural Finance to the Consumer Investment Market #1: Failings of existing suitability

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 is:

• ‍Summary
• #1: Failings of existing suitability
• #2a: Failings of non-existent suitability 1: behavioural capacity
• #2b: Failings of non-existent suitability 2: pension transfers, ESG, and adviser noise
• #3: Behavioural science applied to improving investor education
• #4: Behavioural science applied to breaking down barriers to investment advice

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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:

• accurately assessing each investor’s willingness and ability (both financial and emotional ability) to take investment risk;
• a robust methodology for combining that willingness and ability;
• measuring that overall investor risk in way that matches what is important to investors’ long-term needs; and
• doing so in a way that can be objectively and consistently matched to the risk measurements of available investments.

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:

1. Willingness to take risk (risk tolerance)
2. Financial ability to take risk (risk capacity)
3. Knowledge and experience
4. Determining an investor’s suitable risk level
5. Matching an investor’s suitable risk level to available investments

1. Willingness: unscientific assessments of risk tolerance

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:

• Client (or worse, adviser) self-assessment of risk tolerance – We are poor at assessing something as abstract as our willingness to trade-off the risk and return of long-term outcomes in a way that is independent of short-term context. Evidence suggests that the correlation between self-assessed risk tolerance and that from robust psychometric measures is only 0.4 (very weak).
• Revealed-preference approaches, or gamble/lottery based questions – These questions can be useful for analysing populations at large in academic lab experiments, but for individuals in real-life, results are highly unstable from one test to the next – not what you want to base something as important as the construction of a long-term investment portfolio on. These approaches misleadingly measure not stable, long-term, risk tolerance, but how someone feels about taking risk on the day they are asked.
• Questions requiring numerical or probabilistic reasoning skills – Gamble-based questions are a subset of a wider problem: questions that test not risk tolerance, but maths skills. It’s foolish to think numerical facility can be relied upon at this scale, and in this context.
• Gamification – There is a worrying trend for favouring form over function, and using ‘games’ as elicitation devices for risk tolerance. Gimmicky games trivialise risk tolerance, they do not measure it. Form should follow function, not replace it. Not only is accuracy a concern, but in head-to-head user experience tests of our psychometrically validated assessments against ‘game-based’ competitors it has also become very clear that individuals: a) do not on average find such games more engaging; and b) trust the results less, potentially leading to worse decision-making. An accurate game-based approach isn’t impossible, but the burden of evidence should be placed more firmly on providers of such tools to validate and evidence their accuracy and stability before they are permitted to be used to guide the risk of consumers’ portfolios.

Further reading:

• New Vistas in Risk Profiling
• How not to measure Risk Tolerance,
• Should Risk Profiling have Standardised Scales?
• Measuring the wrong thing…
• Beware style over substance in risk profiling

2. Financial ability: lack of quantifiable and dynamic approaches to risk capacity

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:

1. Measurement failures – Typical approaches are neither quantified, dynamic, nor holistic. A true measure of financial ability to take risk should be all three.
2. Integration failures – Willingness and ability should be measured separately, but compatibly. Suitability rests on combining the two, therefore they need to speak the same language.

We’ll look at integration failures in section 4 of this article.

Typical approaches to measuring ‘ability’ are prone to several common flaws:

• Not quantified – Too often, ability (Risk Capacity, or narrower ‘capacity for loss’) measurements are either subjective guesses, or workarounds such as cash-flow modelling. While these may touch on important factors such as age and non-investible assets, they do not do so in a consistent manner. Nor do they allow consistent integration with Risk Tolerance measures (see point 4 below). Moreover, using complex stochastic forecasting approaches to financial circumstances may ‘work’ as an impressive-looking sales tool, but it can lead to detrimental complexity and spurious precision.
• Not dynamic – Suitability should be as dynamic as the investor circumstances it’s designed to deal with. Willingness – on the whole – doesn’t change. Ability does. Most suitability profiling is over-reliant on an initial assessment, and typically unresponsive to dynamically changing circumstances – either in a client’s life, or in the markets (for the latter, see how suitable risk levels should update in response to shifts in portfolio value).
• Not holistic – Suitability rules seek to match an investor to investments. That investor is a whole human being. Typical approaches forget this. They fall into the trap of dividing the human into a series of ‘pots’, each with their own arbitrary goal, and assessment of what is suitable for meeting that goal. Little effort is paid to how an investors goals interact with each other, or whether each one remains a suitable target as the investor’s journey unfolds. This leads to failing to recognise the valuably flexible nature of a human’s system of goals, as well as failing to take holistic financial circumstances into account with inevitably interdependent financial decisions. (See also A Behavioural Perspective on Goals-Based Investing.)

In addition to these mistakes of omission, there are mistakes of commission:

• Adding a measure of ‘risk required’ – Risk required is not required. If the risk that you’re willing and able to take is not enough to get you to your goals, then use of ‘risk required’ implies unwisely taking risk than you’re either unable or unwilling to take. This is particularly dangerous when target spending is used to encourage investors to take more risk than they are willing and/or able to take. But it also leads to suboptimal outcomes when it’s used to encourage investors to take less risk than they’re willing and/or able to take. The misused notion of ‘risk required’ is particularly pernicious in the current environment as it exacerbates the ‘search for yield’ problem.
• Adding a separate measure of time horizon – All investors have multiple time horizons, and these should be considered as a system. Properly measured, Risk Capacity accounts for the amount and time horizon of each goal and cash flow collectively.

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.

3. Knowledge and experience: onerous-yet-ineffective assessments

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.

4. Determining an investor’s suitable risk level: over-reliance on risk tolerance relative to risk capacity

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.

5. Matching investors to investments

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.

Further reading:

• Training the Elephant in the Suitability Room

Future-proofing is built on robust basics, not shiny new toys

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.

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