MOVING TOWARDS A CONSISTENT LANGUAGE

TAXATION RISK (VAR) RISK INTELLIGENCE

BETA RISK PREFERENCE RISK PERCEPTION MAPPING COMMUNICATION RISK COMMUNICATION RETIREMENT ALPHA RISK EXPECTED SHORTFALL GAP ANALYSIS BLACK BOX RISK BLACK BOX RISK CAPACITY ASSET ALLOCATION RISK DIVERSIFICATION ALPHA

RISK GROUP INFLATION RISK/PURCHASING POWER

EXCHANGE RATE RISK/ COST RISK ASYMMETRY OF INFORMATION RISK

TIMING RISK/MARKET TIMING INVESTMENT Helping you through

AGENCY PROBLEM/PRINCIPAL-AGENT RISK AN ATTITUDE the complex maze of investment risk RISK CAPACITY RISK CAPACITY terminology RISK ATTITUDE/RISK APPETITE RISK ATTITUDE/RISK

CORRELATION RISK PROFILE COUNTRY RISK/SOVEREIGN RISK CAPACITY FOR CAPACITY

REGULATION (COMPLIANCE) RISK REGULATION BALANCE OF RISK

VARIANCE RISK PREMIUM RE-INVESTMENT COUNTERPARTY RISK/DEFAULT COUNTERPARTY INVESTMENT OBJECTIVE/GOAL RISK GAP/RISK MISMATCH BLACK SWAN

ASSET CLASS RISK TOLERANCE (OR RISK PREMIA PARITY)

RISK PROFILING SYSTEMIC//UNDIVERSIFIABLE RISK RISK TOLERANCE SCORE

RISKS OUTSIDE THE NORMAL RISK CLASS VOLATILITY (IMPLIED AND HISTORICAL) CONTENTS

SECTION 1 An introduction to the language of risk 3 1.1 Paul Resnik: why do we need an industry agreed risk lexicon?

1.2 Stuart Erskine: an academic contribution to drive consensus

SECTION 2 The communication challenge

2.1 industry understanding of risk

2.2 customer understanding of risk 6

SECTION 3 Moving towards consensus about the language of risk

SECTION 4 A call to action 10 20

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CONTENTS

SECTION 1 AN INTRODUCTION TO THE LANGUAGE OF RISK

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3 1.1 PAUL RESNIK: WHY DO WE NEED AN INDUSTRY AGREED RISK LEXICON?

FinaMetrica holds a common view that to be trusted you need to behave in a trustworthy manner. It is often argued that four components contribute toward overall trustworthiness. These four key components are, according to Maister, Green and Galford in The Trusted Advisor: reliability – doing what you say you’re going to do; intimacy – being prepared to be vulnerable/ emotionally connected; self-orientation – the degree to which you act in the client’s interests over your own and credibility – the level of expertise demonstrated and how that knowledge is presented. A consistent use of language helps boost individual and industry credibility and, in turn, trustworthiness.

Much of financial services involves explaining the complex as well as creating and nurturing long-term relationships. FinaMetrica strives to facilitate and improve communication between clients and professionals and we also want to drive industry trustworthiness. There are advantages to all from being trusted.

We see standardisation of language and clear communication as the last of the four risk consistencies that ensure an enterprise communicates effectively about risk both internally and with clients. The other three are:

Scalable risk profiling, including scientific risk tolerance assessments, that meet the suitability needs of the full range of clients, from robo-advisors to family offices;

an empirical, rather than a heuristic, foundation for the mapping of risk scores to multi-asset portfolios; and

a practical process to frame investment performance against investors’ risk tolerances and expectations.

There is growing evidence that investors with unframed risk and investment expectations run underperforming portfolios. They are prone to emotional responses, leading to value diminishing market timing. Simply put, they trade in response to the news, buying high and selling low more often than not.

In a client-focused world there should be no investment surprises. Consistency of communication is a major contributor to that goal.

For all these reasons FinaMetrica financially sponsored this project, retaining Stuart Erskine to research and write this lexicon in conjunction with a number of industry and academic specialists.

4 5 1.2 STUART ERSKINE: AN ACADEMIC CONTRIBUTION TO DRIVE CONSENSUS

Paul Resnik set me an interesting challenge regarding reaching consistent risk terminology; I hope the following begins to stimulate debate with the result of leading towards consensus.

The Oxford English Dictionary cites the earliest use of the word “risk” from 1655. The dictionary definition of risk is: “the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such apossibility”.

Within the arena of financial services there is no consensus or working definition of risk. In their 2004 paperUnderstanding and Managing Risk Attitude David Hillson and Ruth Murray-Webster summarise the vagaries and lack of consensus surrounding risk: “The word “risk” is a common and widely-used part of today’s vocabulary, relating to personal circumstances. Yet somewhat surprisingly, there is still no broad consensus on the meaning of this term. Various national and international standards and guidelines exist which mention risk, but there are many different definitions and underlying concepts in these documents”.

This report will be circulated around leading financial institutions for comment. Stuart Erskine would like to thank Dr Andrea Vedolin of the London School of Economics for her help in researching and compiling this paper; all errors and omissions are the responsibility of Stuart Erskine.

About FinaMetrica

The FinaMetrica Risk Tolerance Toolkit™ helps advisors and enterprises create lifetime clients through better financial advice. It was launched in 1998, developed and trialed in Australia over four years with the assistance of the University of New South Wales. It’s now maintained with senior academics from the London School of Economics and has gained international recognition as the world’s best practice risk profiling. The Toolkit’s reliability and validity is backed by over a million profiles set up by thousands of independent financial advisors in over 20 countries.

Contacts:

Stuart Erskine is based in the UK. He can be contacted at [email protected]

Nicki Potts is FinaMetrica’s COO and is based in Sydney. She can be contacted at [email protected]

Paul Resnik heads FinaMetrica’s business development and is largely peripatetic. He can be contacted at [email protected]

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SECTION 2 THE COMMUNICATION CHALLENGE

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6 7 2.1 INDUSTRY UNDERSTANDING OF RISK

For all the advantages of the investment industry being more consistent in the way it talks about risk, one stands out above the rest. Trust. We have noted already that to be trusted you have to behave in a trustworthy manner. The mis-selling scandals in the industry over the past two decades have had a particularly corrosive effect on consumer perception of financial services. And if there’s one theme those scandals have shared, from Payment Protection Insurance (PPI) in the UK market through to the mis-selling of financial products by the Commonwealth Bank of Australia and the massive subprime mortgage crisis in the US, it’s suitability.

Deliberately or otherwise, the industry has sold products on a huge scale to people for whom they were not appropriate. At the core of suitability is the issue of risk, because an unsuitable product is invariably one that doesn’t match an individual’s risk profile. The extent to which an investor understands the risk that a product entails, or the level of risk they’re comfortable taking, depends largely on how well those issues have been communicated and discussed. If an adviser, fund provider or pension scheme is unable to communicate risk in a way that an investor can understand, confusion and failings in suitability assessment will often follow.

That’s why the effectiveness with which the industry communicates with its customers on the subject of risk is high on the agenda of financial egulatorsr across the globe. A recent report into current practices for risk profiling in the Canadian financial services market pointed to statistics from The Investment Industry Regulatory Organization of Canada (IIROC) which revealed that risk tolerance was the number one area of regulatory violation that moved to prosecution. The study argued that there is a “confusing and universal lack of existence or consistency of the definitions of risk concepts” amongst Canadian regulators, providers and academics alike. Regulators in particular were criticised in the report for their use of different risk terms “as if each meaning is obvious or known” but which fail to make it clear to stakeholders what the regulatory intent or requirement actually is.

In the US market, which is currently leading the way when it comes to the development of digital advice, the Financial Industry Regulatory Authority (FINRA) has raised concerns over the adequacy of robo risk tolerance compared to human financial advice, particularly when many of these new tools only ask a small number of questions regarding an investor’s attitude towards risk. The US regulator has also been reinforcing the need for broker- dealers to implement effective governance and supervision of digital advice tools in order to fully assess risk tolerance.

The UK’s Financial Conduct Authority (FCA) looked at the issue of communicating risk in a thematic review on Meeting investors’ expectations published in April 2016 (TR 16/3). The study, which sampled 23 UCITS funds worth approximately £50bn in total, examined (among other things) how

7 2.1 INDUSTRY UNDERSTANDING OF RISK

investors were considered when designing investor communications and the extent to which firms ensured fund documents were clear, accurate and consistent with one another, including the of investing in particular funds. It found that while most firms disclosed the key risks in their funds, seven KIIDs failed to clearly explain the consequences of risks, potentially leaving some investors without a clear understanding of how these could impact the value of their investment. One in particular was singled out for using “lots of jargon”, meaning investors “might not have understood the risks of investing in the fund”. The paper also picked out examples of good practice, including a table in one prospectus setting out the risks to which each fund was exposed, making it “easy for investors to identify the risks relevant to a particular fund and choose investments with appropriate risk profiles”. The consistent communication of risks was a theme across the examples of good practice, but those firms were in a small minority.

Communicating the different types of risk faced by investors isn’t easy, which is why consistency is so important. Some firms are clearly better than others, but even then the range of approaches taken to explaining risk makes effective comparison difficult. While some use simple measures such as the visual presentation of key information, others continue to employ jargon that only creates additional confusion, particularly where there is a high level of risk illiteracy among investors.

Standardisation of language has evident benefits - investors are more likely to understand the risks of certain investments and how they relate to their own risk appetites and attitudes. They know what to expect, which means they are more likely to respond appropriately to market volatility and crises. They are also able to compare different providers and products more effectively and, arguably, develop a better understanding of the broader concept of risk.

The final point is an important one, because industry shortcomings in communicating risk can arise from failing to appreciate the difference between their own understanding of risk and that of the investor. Explaining complex subjects to people who don’t have your expertise in them, or even a basic understanding, is undeniably difficult at times. However, it would be made far easier with consistency of communication, using an agreed, standardised language that provides greater clarity and understanding for both consumers and the industry.

8 9 2.2 CUSTOMER UNDERSTANDING OF RISK

For now, at least, a big question mark still hangs over the customer’s understanding of risk. We have already highlighted the issues that major financial services markets have when it comes to communicating risk effectively. For ordinary investors, this lack of consistency and clarity at an industry level has clearly resulted not just in confusion but, in some cases, irrevocable losses.

It is our hope that this paper can spark the debate and, in time, the change required throughout the industry to create a unified language of risk that is comprehensive and clear enough to make the world of financial services that little bit simpler for the people for whom it matters most: the end clients.

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SECTION 3 MOVING TOWARDS CONSENSUS ABOUT THE LANGUAGE OF RISK

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10 11 MOVING TOWARDS CONSENSUS ABOUT THE LANGUAGE OF RISK

Economist and consultant Stuart Erskine, with reward by adjusting the percentage of each input from Dr Andrea Vedolin, have compiled asset in an investment portfolio according to the the following glossary of terms that set out a investor’s risk tolerance, goals and investment framework for communicating risk. Outlining time frame. their views on appropriate terms and definitions, the authors hope to create the beginings of a 4. Asset class: is a group of securities that have comprehensive and consistent risk language that similar financial characteristics, behave similarly should help drive the debate towards common in the marketplace, and are subject to the same terminology regarding in the retail laws and regulations. The main asset classes financial sector. are viewed traditionally as equities (stocks), fixed-income (bonds), real estate (property), 1. Agency problem/principal agent risk: exists commodities and cash. where the agent’s motivation is not in line with the principal’s (the investor). The conflict of 5. Asymmetry of information risk: is the interest between the principal and the agent situation in which one party involved in who is acting on behalf of the principal. Typical a transaction has more (usually superior) examples include the management (agent) information compared to the other party(ies). and shareholders (principal) who is acting on This may be a harmful situation when one party her/his own (personal) best interest contrary takes advantage of the other party’s lack of to maximising shareholder value. The agency knowledge/information deficit. problem therefore arises when (a) the desires or goals of the principal and agent conflict and (b) it 6. An attitude: is a positive or negative evaluation is difficult or expensive for the principal to verify of people, objects, events, activities, and ideas. It what the agent is actually doing. can be concrete or abstract. Eagly and Chaiken (The Psychology of Attitudes) define an attitude as 2. Alpha: is often interpreted as representing the “a psychological tendency that is expressed by skill of the fund manager. The excess return evaluating a particular entity with some degree of above the relevant index’s risk/reward profile. favour or disfavour.” The difference between a fund’s expected returns based on its beta (market ) and its 7. Beta: is a measure of the volatility, or systematic actual returns. Alpha is a parameter in the capital risk, of a security or a portfolio in comparison asset pricing model and essentially a measure to the market as a whole. A measure of 1 would of the active return of the investment manager. mean an investment’s movements are exactly in Alpha is a percentage number where positive line with the market, 0 indicates no relationship values indicate the fund’s superior performance and -1 indicates that the security co-moves beyond a benchmark index and negative values inversely with the market. Beta indicates whether indicate the reverse; that is inferior performance. an investment is more or less volatile than the market; or indeed not influenced by it. 3. Asset allocation: is the process of balancing risk of a portfolio by spreading, or ‘diversifying’, 8. Balance of risk: is the balance between risk investments across a range of different asset tolerance and risk capacity. When the amount classes and geographical regions to reduce the of necessary risk equals the level the investor is overall risk of all the investment components comfortable taking, balance is achieved. of the portfolio falling in value at the same 9. : The risk associated with imperfect time. To maximise the potential for smoother, hedging. It is the difference between the price of and therefore higher, compound returns. The the asset to be hedged and the price of the asset argument for diverse asset allocation is that serving as the hedge, or because of a mismatch portfolio returns are heavily driven by the between the expiration date of the hedge asset underlying asset allocation. Asset allocation is and the actual selling date of the asset (calendar therefore the implementation of an investment basis risk). strategy that attempts to balance risk versus

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10. Black box risk: (akin to information asymmetry) More specifically, risk communication is the act of when specific knowledge about a system’s conveying or transmitting information between internal operations are not known. parties about (a) levels of investment risks; (b) the significance or meaning of investment risks; or (c) 11. Black swan event (aka fat tailed event): decisions, actions, or policies aimed at managing Popularised by Nassim Taleb, it is a low- or controlling investment risks. probability, high-impact event that is almost impossible to forecast. The disproportionate role 16. Complexity risk: Financial investments which of high profile, hard-to predict, and rare events are complex, multi-layered, and are difficult to that are beyond the realm of normal expectations articulate and/or understand become inherently in history, science, , and technology. risky as informed consent with a client is not The non-computability of the probability of possible. the consequential rare events using scientific methods. 17. Correlation: is a measure of the relationship between two random variables. The value can 12. Capacity for loss: is the extent to which worse be positive or negative. Perfect correlation will than anticipated outcomes can be absorbed have a value of 1 meaning the variables move without impacting the achievement of important identically in the same direction, 0 means no goals. Risk capacity can be evaluated by analysing correlation and -1 means an perfect inverse an investor’s financial circumstances and relationship. investigating the impact of different scenarios before financial decisions are made. Risk capacity 18. Cost risk: The appearance of previously unknown is therefore the extent to which a risky event costs or level of known costs increases. (loss) can happen e.g. a market crash without damaging the person’s stated financial goals. The 19. Counterparty risk/Default risk (including risks FCA defines capacity for loss as “the customer’s incurred by hedging): The risk to each party to ability to absorb falls in the value of their a contract that the counterparty will not meet investment. If any loss of capital would have a its contractual debt obligations. Exampled by materially detrimental effect on their standard Russian banking crisis default risk. of living, this should be taken into account in a. Credit default risk: The risk of loss arising from assessing the risk that they are able to take”. a debtor being unable to pay its loan obligations. 13. Capital asset pricing model (CAPM): is a model b. Credit default swap: A financial contract used to determine the rate of return of a risky whereby a buyer of corporate or sovereign asset. In the most basic model, the rate of return debt tries to hedge credit or sovereign risk by of a stock is related to the market risk. According the issuer of the bonds. The buyer of the swap to the CAPM, the risk of the stock should only makes payments to the swap’s seller up until be determined of how stocks co-move with the the maturity of the contract. In case of a default, market (see 7. Beta). the seller agrees that they will pay the buyer 14. : is the risk that the value of an the security’s premium as well as all interest asset will be adversely affected by fluctuations in payments between the time of default and the prices of commodities. maturity of the .

15. Communication risk: is the failure of process 20. Concentration risk: The risk associated with and/or understanding within any purposeful any single exposure (non-diversification) with exchange regarding the two-way process the potential to produce large enough losses between the communicator(s) and the recipient(s) to threaten an entire portfolio. Often used in of the messages. The authors have adapted connection with banks’ exposure to specific Covello et al’s definition to fit investment risk loans or assets. It is the risk posed to a financial “any purposeful exchange of information about institution by any single or group of exposures investment risks between interested parties”. that have the potential to produce losses large

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enough to threaten the ability of the institution analysis therefore involves the comparison of to continue operating. actual performance with potential or desired performance. 21. Country risk/Sovereign risk: The risk of loss arising from a sovereign state (government or 28. Hedge (risk): is an investment (position) intended country) not complying with the terms of a loan/ to offset potential losses/gains that may be debt agreement; this type of risk is associated incurred by another investment within a portfolio. with the country’s wealth/macroeconomic performance and its political stability. A recent 29. Holding period risk: The longer the term of example is the Greek debt crisis. the bond, the greater the chance that a more attractive investment opportunity will become 22. Diversification: A risk management technique available, or that other factors may occur that that mixes a wide variety of investments/asset negatively impact the investment. classes within a portfolio to reduce the overall volatility (risk) of that portfolio. To allocate capital 30. Implied volatility: is the volatility extracted from in a way that reduces the exposure to any one options (opposed to stocks). Since options are particular asset or risk. “Don’t put all your eggs in contracts/bets on how assets will perform in the one basket”. future, implied volatility is often used to extract investors’ expectations about future volatility. 23. Downside risk: is the financial risk associated The most prominent example is the so-called VIX with loss or the risk of the return on an which is the implied volatility extracted from S&P investment to be less than expected. It is often 500 options. The VIX is often referred to as an presented as the worst case scenario for an investor fear gauge. investor. 31. Investment objective/Goal: This is the investor’s 24. : is the risk that the price of a stock/ personal and lifestyle objectives converted into share will change. monetary targets. The performance is measured by the success of investments in meeting an 25. Expected shortfall: is the expected loss individual’s personal and lifestyle (financial) goals. conditional on value-at-risk being violated. The expected shortfall takes the shape of the tail 32. Investment suitability: is defined by the FCA as distribution into account while the value-at-risk the process by which “an investment firm must does not. It is usually calculated in addition to the take reasonable care to ensure the suitability value-at-risk. The expected shortfall, however, of its advice and discretionary decisions for is difficult to measure as the tail distribution is any customer who is entitled to rely upon usually unknown. its judgement”. Investment suitability is the foundation upon which good investment advice 26. Exchange rate risk/Foreign exchange risk: In process is built. The creation by an adviser relation to a transaction it is the risk that before with the investor of an agreed financial plan the date when the transaction, is completed there that is likely to meet the investor’s needs and may be an adverse movement in the exchange of expectations. The investment advice must be the denomination currency in relation to the base suitable with regard to an investor’s goals, and currency. Exchange rate risk can be hedged using also with regard to risk, that is, their risk capacity foreign exchange futures and forwards. and risk tolerance.

27. Gap analysis: describes the process by which 33. Inflation risk/Purchasing power risk: is the risk an investor’s risk tolerance can be compared to that the cash flows from an investment will not be the risk or return required from an investor’s worth as much in the future because of changes portfolio to achieve their stated goals. There is in purchasing power due to inflation. That is a often a mismatch between the ways in which reduction in the real value of money from sustained risk tolerance, risk required and gap analysis increases in the general price level of goods and describe how the mismatch is resolved. Gap services in an economy over a period of time.

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34. Interest rate risk: arises for bond owners from 39. Measurement error: All tests are subject to fluctuating interest rates. The interest rate risk errors, the errors can vary in magnitude and can depends on how sensitive the bond’s price is be systematic errors e.g. a watch that consistently to changes in interest rates. This sensitivity in loses 5 minutes a day; these errors are often less turn depends on two things: the bond’s time serious as they are predictable. Random errors to maturity and the coupon rate of the bond. are more serious as they impact the accuracy of Interest rate risk is usually referred to as duration the measurement. The lower the error in a test, risk. the more reliable the test is.

35. Liquidity (risk): is the risk that an investment 40. Model (mapped) portfolios: Defined as a series becomes more difficult to buy or sell. It is most of investment solutions that can be characterised commonly measured by the size of the bid and by a consistent risk profile, asset allocation and in ask (offer) spread. most cases fund selection. In the FCA’s Financial Guidance 12/15: the FCA described “model portfolios 36. Mapping (implementation/financial plan) risk: to mean a pre-constructed collection of designated Risk of mapping from a stated financial plan or investment, including some retail investment requirement to actualising the plan. This includes products that meet a specific risk profile, sometimes moving from a stated risk score to an asset offered with a periodic rebalancing of investments allocation. to maintain a consistent asset allocation. Model portfolios allow a firm to pre-determine what will 37. Market risk: often mis-used interchangeably generally be its advised asset allocation for certain with beta and systematic risk. Market risk is investment objectives or attitudes to risk, and to the risk that the underlying market variables distil its product research in line with these asset change over time; that is any variable that has allocations”. an impact on the market. 41. Political risk: is political change that affects the 38. Market concentration risk: Much of the expected outcome and value of a given economic finance theory underlying statistical risk models action by changing the probability of achieving make the critical assumption that markets are business objectives. largely frictionless—that they work smoothly and cheaply. In a frictionless market, financial 42. Profit risk: is a risk that earnings are institutions take prices as given rather than concentrated, derived from a limited number of changing them during transactions. But this revenue streams e.g. small number of customers. can lead risk managers to ignore risks arising This results in (vulnerability) net income risk. from market frictions, which can be introduced when a single institution accounts for a very 43. Regulation (compliance) risk: overlaps with large amount of a market’s transactions. An political and taxation risk. The risk that a change historic example is the hedge fund Long-Term in laws and regulations may impact an equity, Capital Management (LTCM) which collapsed, in business sector or market. A change in laws or 1998, holding extremely large positions in the regulations made by a regulatory body may affect index option market that got exercised after the the business proposition and operating model Russian debt default in August 1998. During the itself and the costs of running a business, reduce fund’s crisis it was unable to change its positions the attractiveness of investment and/or change because other counterparties wanted large the competitive landscape. Similar impact to the discounts in order to trade on the scale LTCM actual legislation change may also stem from required. When a big firm realises losses from changing interpretation of regulation leading to a the forced sale of assets at discounted prices, it compliance interpretation risk. may well drag down prices for other institutions holding those or related assets, in turn making 44. Risk: In the absence of certainty, (financial) risk is the institutions less creditworthy because their the variance of possible financial outcomes. The assets are worth less. uncertainty associated with any investment. That is, risk is the possibility that the actual return on

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an investment will be different from its expected with low risk composure may have a tendency to return. The potential of gaining or losing monitor their portfolio more frequently. something of value. Risk is usually measured by volatility, value-at-risk, or expected shortfall. 49. Risk-free return: is often cited as the return of a default-free bond with short maturity. The most 45. Risk attitude/Risk appetite: a measure of how common risk-free rate is the LIBOR (London a person feels about financial risk. The person’s Interbank Offered Rate). attitude towards taking financial risk. The amount and type of risk that an organisation is willing to 50. Risk gap/Risk mismatch: (See 8. Balance of take in order to meet its strategic objectives. An risk) mismatch exists between risk required, investor’s risk attitude is usually described as risk risk tolerance and risk capacity. Trade-offs then averse or risk-seeking. become necessary to resolve the mismatch and give suitable financial advice. People often can’t 46. Risk aversion: is the behaviour of investors achieve their financial goals from the resources and consumers to reduce uncertainty. Risk they have available. So investors, with the adviser’s averse investors prefer a low pay-off with help, must prioritise and trade-off some goals in higher certainty to a higher pay-off with more order to achieve others whilst keeping within their uncertainty. For example, imagine an investor agreed risk tolerance and risk capacity. The trade- is given the choice between two assets, one off decisions themselves are made by the investor with a guaranteed pay-off (bank account according to his or her values and preferences and which pays interest) and one without (a stock). documented by the adviser. The guaranteed investment pays £50, the risky investment either pays £100 or nothing 51. Risk group: After answering a risk tolerance with probability 0.5. In expectation, both the questionnaire, respondents with similar risk guaranteed and risky asset pay £50, yet a risk- tolerance levels are put into a risk group based on averse investor would prefer the guaranteed their risk tolerance “score”. investment rather than taking the gamble. A risk-loving investor would prefer the riskier 52. Risk intelligence: is cited as the approach to investment and a risk-neutral investor is protect and create value amid uncertainty. It indifferent between the two investments. is often viewed as an enterprise wide process integrating people, processes, systems or tools 47. Risk capacity: This has been used to increase information available to decision interchangeably with the term capacity for makers for improved decision making. loss (see 12. Capacity for loss). In addition, the authors are aware that risk capacity has 53. Risks outside the normal risk class: Risk also been used to describe the amount of risk managers often distinguish among market, that the investor “must” take in order to reach credit and operational risks, which they measure financial goals. The rate of return necessary to differently and in isolation. Companies that reach these goals can be estimated by examining fail to assess risk firm-wide do not go beyond time frames and income requirements. Rate of these measures, effectively assuming that the return information can then be used to help the three types of risk aren’t correlated. Thus it is investor decide upon the types of investments to crucial to measure risk in ways that cut across engage in and the level of risk to take on. organisational silos and include all the material risks to which a firm is exposed. 48. Risk composure: is how much an individual feels and responds to short-term gains and losses 54. Risk premium: is the return in excess of the risk- in their portfolio. A low composure means that free rate that an investment is expected to yield. an individual is more sensitive and therefore at It is the compensation to invest in a risky asset higher risk of responding emotionally to short- compared to the risk-free asset. The most prominent term market fluctuations. They are more likely to example is the equity premium which measures the change their investments because of short-term extra return an investor earns by holding the index events through the market cycle. Individuals compared to the risk-free rate which is available.

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55. Risk preference: an investor uses a combination an action feels to them. Different people make of subjective and objective cognitive evaluations different estimates of the dangerousness or to generate his/her “risk preference”. There may gravity of risks. These risk perceptions can change not be justification for the individual’s feelings and are not necessarily rational. When investment regarding their preferences. markets are booming, for example, people tend to underestimate the level of financial risk. When 56. Risk parity (or risk premia parity): is an markets are falling, people tend to overestimate approach to investment portfolio management the risk. which focuses on allocation of risk, often defined as volatility. The risk parity approach asserts that 63. Re-investment risk: An example of re-investment when asset allocations are adjusted, the risk risk may occur when certain investment products parity portfolio can achieve a higher mature before their defined maturity date e.g. and can be more resistant to market downturns “kick-outs” or “autocalls” on structured products than the traditional. or when bonds are paid back early. The risk itself comes from the fact that when the investor seeks 57. Risk profile: The optimal level of investment a new place to investment that money, there may risk for an individual having regard for the risk not be another suitable investment available with required, risk capacity and risk tolerance. an equivalent return or interest rate.

58. Risk profiling: The process of determining the 64. Retirement alpha: Maximising an individual’s optimum level of investment risk for an individual, retirement income/financial situation. An example having regard to risk required, risk capacity and risk of this would be defining the amount to pass on tolerance. in inheritance, purchasing an insurance policy to cover this and then allowing the remaining sum 59. Risk required/Risk needed: The risk associated to be fully invested/generate maximum income. with the return required to achieve an investor’s goal. An investor’s current and future financial 65. Sequence risk: The risk of receiving lower returns position is considered, including their income, early in a period when withdrawals are made savings, expenses and liabilities and then from the underlying investments. The order or determining the rate of return they require to the sequence of investment returns is a primary achieve their financial goals. Other factors may concern for those individuals who are retired be involved in assessing risk required which and living off the income and capital of their include: state of health, longevity, inheritances, investments. Sequence risk suggests that a steep tax, children’s education, retirement, long-term or sustained market decline in the early years of healthcare and discretionary spending. income distribution can have a lasting negative impact. Conversely, a sustained market increase 60. Risk tolerance: is an individual’s general early on can provide a boost that can carry an willingness to take risk (potential loss) towards investor through future market declines. achieving their financial objectives. It is the amount of risk or the degree of uncertainty that they are 66. : is the risk that the profile of hedging comfortable taking. does not match the granularity/profile of the risk being hedged. 61. Risk tolerance score: A relative scale showing the level of risk tolerance for an individual, often 67. Sharpe ratio: is the investment return adjusting where a higher score represents the more risk- for the risk taken. It measures the excess return seeking the individual is. (risk premium) per unit of risk taken.

62. Risk perception: is the subjective judgment 68. Skin-in-the-game: is to have monetary risk by that people make about the characteristics and being involved in an investment. It is used to severity of a risk. Risk that a person sees in taking convey a principal’s significant equity stake in a particular course of action, that is, how risky an investment. One typical example of skin-in-

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the-game is capital commitments which have 75. Uncertainty: is a state of not knowing whether long been an integral feature of the hedge fund a proposition is true or false. A situation that industry to align investment managers with involves imperfect and/or unknown information. their clients. 76. Value at Risk (VaR): estimates how much an 69. : Similar to the Sharpe Ratio that investment might lose within a specified time explains the excess return earned per unit of period, often a day; the maximum amount of risk. While the Sharpe Ratio looks at any price money you might lose at a given probability level. movement (up or downward), the Sortino ratio For instance, a VaR of £100 million at the 1% level only takes into account downside deviations. means that you have only a 1% chance of losing more than that amount over the next day. A bank 70. Specific risk/Unsystematic risk/Idiosyncratic assigns an upper limit to the VaR it is willing to risk: is risk that affects individual assets within accept say, £125 million, in which case it would be a portfolio. The risk is able to be diversified comfortable with a 1% probability of losing £100 away/hedged. million as it is less than VaR maximum.

71. Systematic risk: Often referred to as aggregate 77. Value-assumption risks (illiquidity): exists risk. Systematic risk arises from the market where there is doubt about the true value of structure or its dynamics and affects all investors traded assets when markets are illiquid. This and assets in the markets. This is in contrast to causes market participants to stop taking prices idiosyncratic risk which only affects individual as given because transactions are too infrequent investors or assets. Idiosyncratic risk can be to provide clear price signals. diversified away whereas systematic risk cannot. In the CAPM, the market risk is referred to as the 78. Variance: is the expectation of the squared systematic risk. deviation of a random variable from its mean. It measures how far a set of numbers spread 72. : is the risk of a collapse of a out from their mean. A small variance indicates market opposed to risk associated with a single that the data points tend to be close to the group. Systemic risk refers to the risks imposed mean (expected value) and thus to each other. A by linkages and dependencies in a market. high variance indicates that the data points are The default of Lehman Brothers is one of the dispersed out around from the mean and from most cited examples as the default of this bank each other. triggered the default of other market participants through market linkages. 79. Volatility: is the degree of variation of a trading price/value over time as measured by the 73. Taxation risk: The risk that tax laws/systems standard deviation or variance of return. relating to financial products and assets may change impacting previous and future relative attractiveness/outcomes of particular investment strategies.

74. Timing risk/Market timing: explains the potential for missing out on beneficial movements in price due to an error in timing of the investment e.g. being out of the market. It is the risk that an investor takes when trying to buy or sell a stock based on future price predictions.

17 MOVING TOWARDS CONSENSUS ABOUT THE LANGUAGE OF RISK

BIBLIOGRAPHY

Please note that due to the nature of the online sources featured in the bibliography, some of the links below may have to be manually copied into your browser in order to read the full article.

Addagada, T. C. (n.d.). Do we need a mature gap Cornett, M. M., & Saunders, A. (n.d.). Financial analysis? Retrieved from BA Times: https://www. Institutions Management: a risk management batimes.com/articles/do-we-need-a-mature-gap- approach (5th ed). McGraw-Hill/Irwin. analysis.html Country Risk survey results Q1 2016. (n.d.). Retrieved Assessing suitability of investments. (n.d.). Retrieved from Euromoney: http://www.euromoney.com/ from Financial Ombudsman Service: http:// poll/10683/PollsAndAwards/Country-Risk.html www.financialombudsman.org.uk/publications/ technical_notes/assessing-suitability-of- Covello, V. T., Slovic, P., & von Winterfeldt, D. (1986). investment.htm Risk communication: an emerging area of health communication research. Barro, R. J. (1997). Macroeconomics. Cambridge, Mass: MIT Press. De Giorgi, E. G., & Thaler, R. H. (2009). Goal-based investing with cumulative prospect theory and Bartram, S. M., Burns, N., & Helwege, J. (2013). Foreign satisficing behaviour.Department of Economics, currency exposure and hedging: evidence from University of St. Gallen. foreign acquisitions. Quarterly Journal of Finance Vol. 3 No. 2. Eagly, E., & Chaiken, S. (1993). The Psychology of Attitudes. Wadsworth Publishing Co Inc. Blasingame, J. (n.d.). Creating a retirement alpha plan, an interview with Tom Henga. Retrieved Elton, E. J., & Gruber, M. J. (1977). Risk reduction from Small Business Advocate: http://www. and portfolio size: an analytic solution. Journal of smallbusinessadvocate.com/small-business- Business Vol. 50 No. 4 p.415-437 interviews/tom-hegna-14771 Evans, D. (2012). Risk Intelligence: how to live with Bremmer, I. (2009). Political risk: Countering the impact uncertainty. New York: Free Press. on your business. Retrieved from QFinance: http:// www.financepractitioner.com/business-strategy- Federal Reserve Bank of Chicago. (2009). Health and best-practice/political-risk-countering-the-impact- the savings of insured versus uninsured, working-age, on-your-business?page=1 adults in the US.

Brinson, G. P., Hood, R. L., & Beebower, G. L. (1985- Financial Conduct Authority. (n.d.). Assessing suitability: 1994). Determinants of Portfolio Performance. Establishing the risk a customer is willing and able Retrieved from CFA Institute Publications: to take and making a suitable investment selection. http://www.cfapubs.org/doi/abs/10.2469/faj.v42. Retrieved from Financial Conduct Authority: n4.39?journalCode=faj https://www.fca.org.uk/static/documents/final- guidance/fsa-fg11-05.pdf Chamber, R. G., & Quiggin, J. (2000). Uncertainty, Production, Choice and Agency: The State-Contingent Financial Conduct Authority. (n.d.). TR16/3 Meeting Approach. Cambridge University Press. investors’ expectations. Retrieved from Financial Conduct Authority: https://www.fca.org.uk/news/ Concentration Risk. (n.d.). Retrieved from Visible Equity: tr16-03-meeting-investors-expectations http://www.visibleequity.com/creditrisksoftware/ Learn/concentration-risk-methodology.jsp Financial Markets Group and Chicago Federal Reserve Bank of Chicago. (2013). Understanding Derivatives: Markets and Infrastructure (revised ed.).

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First Quadrant Perspective and Martin Steward. Reducing the risk of policy failure: challenges for (n.d.). The truly balanced portfolio. Retrieved from regulatory compliance. (n.d.). Retrieved from Investment and Pensions Europe: http://www.ipe. Organisation for Economic Co-operation and com/the-truly-balanced-portfolio/37013.fullarticle Development: http://www.oecd.org/regreform/ regulatory-policy/1910833.pdf French, C. W. (2003). The Treynor Capital Asset Pricing Model. Journal of . Report on Digital Investment Advice. (2016). Retrieved from FINRA: http://www.finra.org/ Funston, F. (2010). Surviving and thriving in uncertainity: sites/default/files/digital-investment-advice-report. creating the risk intelligent enterprise. Hoboken: pdf?utm_source=MM&utm_medium=email&utm_ John Wiley & Sons. campaign=NewsRelease_031516_FINAL

Hillson, D., & Murray-Webster, R. (2007). Retail Distribution Review: Independent and restricted Understanding and Managing Risk Attitude. Gower. advice. (n.d.). Retrieved from Financial Conduct Authority: http://www.fca.org.uk/your-fca/ Holton, G. A. (2014). Value-at-Risk: Theory and Practice. documents/finalised-guidance/fsa-fg1215 Academic Press Inc. Sharpe, W. (1970). Portfolio Theory and Capital Markets. Implied Volatility Numerical Methods. (2014). Retrieved McGraw-Hill Trade. from R. Akke Financial Professional: http://www. ronakke.com/BSIV-Numerical-Methods.html Shiller, R. (1995). Aggregate Income Risks and Hedging Mechanisms. Quarterly Review of Infanti, J., Sixsmith, J., Barry, M., Núñez-Córdoba, Economics and Finance. Vol. 35 No. 2 p. 119-152 J., Oroviogoicoechea-Ortega, C., & Guillén- Grima, F. (n.d.). A literature review on effective risk Simons, T. (2008). The Integrity Dividend: Leading by the communication for the prevention and control of Power of Your Word. John Wiley & Sons. communicable diseases in Europe. Retrieved from European Centre for Disease Prevention and Stiglitz, J. E. (n.d.). Information and the change in the Control: http://ecdc.europa.eu/en/publications/ paradigm in economics. Retrieved from Nobel Prize: Publications/risk-communication-literary-review- http://www.nobelprize.org/nobel_prizes/economic- jan-2013.pdf sciences/laureates/2001/stiglitz-lecture.pdf

Johnson, R., & Wichern, D. (2001). Applied Multivariate Sullivan, A., & Effrin, S. M. (2003). Economics: Principles Statistical Analysis. Prentice Hall. in Action. Prentice Hall.

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Peters, E. (2009). Balancing Betas: essential risk Vose, D. (2000). Risk analysis: a quantitative guide. John diversification.Retrieved from First Quadrant: Wiley & Sons. https://www.firstquadrant.com/system/ files/2009_02_Balancing_Betas.pdf Westerfield, R., & Jordan, B. D. (2010).Fundamentals of Corporate Finance. McGraw-Hill Higher Education. PlanPlus Inc. (2015). Current Practices for Risk Profiling in Canada and Review of Global Best Practices. Retrieved from Ontario Securities Commission: http://www.osc.gov.on.ca/documents/en/ Investors/iap_20151112_risk-profiling-report.pdf

19 X

SECTION 4 A CALL TO ACTION

X

X

20 21 A CALL TO ACTION

The conversation around the language of risk of risk, then a careful plan will need to be should not stop here. The parameters set out implemented to ensure it reaches all interested in this report are very much intended as a parties. Establishing exactly which businesses starting point that can be relied upon as a sound, within the industry are likely to be interested academically-researched interpretation of what and will benefit from using the language of constitutes consistent communication around risk is a good place to start. Drilling down even risk. But for any of this to have a positive impact further, determining the types of teams and/ on the end consumer, the framework itself needs or individuals within a company that would to be communicated effectively throughout our actually use the framework is also important, own industry first. as a back-office team member may be less likely to require this than, say, a client services The ultimate aim is to encourage relevant manager. Generating initial awareness around representatives from businesses across the the language of risk in these target areas of the financial services industry to come together to market and highlighting why it is important will form a working group, led by Stuart Erskine, and also be essential. take the language of risk forward by transforming what is an initial concept into a practical toolkit The language of risk is not something that will that can be used by firms throughout the sector. remain static. The financial services industry never stands still and our framework should be But before any of this takes place we would like to adapted accordingly over time to allow for any invite those working in and around the financial new risk language that may emerge as a result of services industry to contribute their views and technology or industry developments in this ever- suggestions around this report. By no means do changing sector. we think this paper has the final say on what the language of risk should be. Quite the opposite: Of course this constantly evolving landscape also the sector is diverse and often complex, meaning means that the financial services industry has no that a comparison of industry opinion is an shortage of demands on its time already, most essential first step to ensure that the framework significantly from regulatory pressure but also as accurately reflects its many facets. Does it account a result of technological change and the outlook for specific nuances and issues facing their area for the wider business environment. The language of the industry? Is it understandable and versatile of risk may seem a small issue by comparison but, enough to cover different customer’s financial as this report highlights, nuances in the way we needs and levels of investment knowledge? communicate risk lie at the heart of some of the Both additions and omissions are likely to be biggest challenges faced by the industry. It is with made as part of this process and a consensus this context in mind then that we would like to will eventually have to be agreed by all parties invite readers to share their thoughts with us as involved but the final result will be a workable we look to begin the next stage in establishing the document with the potential to be applied language of risk. industry-wide. If you’d like to be involved in helping develop Of course there will also be many practical an industry agreed language of risk, please considerations to factor in along the way. If the contact Stuart Erskine in the first instance at overall aim is to be able to roll out the language [email protected].

21 Dr Andrea Vedolin is an Assistant Professor of Finance at London School of Economics. She has written widely on financial risk and uncertainty.

Stuart Erskine MA has an academic background in economics and has worked extensively in the financial services sector in a variety of roles including on the academic side as an examiner for a professional standard body.

Since 1970 Paul Resnik has been active in the financial services community, initially in Australia and more recently around the world. He has worked in all parts of the service supply chain, and founded consulting, financial planning, platform, conference, recruitment, life insurance & businesses, in addition to co-founding FinaMetrica in 1994.

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