MOVING TOWARDS A CONSISTENT RISK LANGUAGE TAXATION RISK VALUE AT RISK (VAR) RISK INTELLIGENCE BETA RISK PREFERENCE RISK PERCEPTION MAPPING COMMUNICATION RISK COMMUNICATION RETIREMENT ALPHA RISK PREMIUM RISK HOLDING PERIOD RISK EXPECTED SHORTFALL GAP ANALYSIS BLACK BOX RISK BLACK BOX RISK CAPACITY ASSET ALLOCATION MARKET RISK HEDGE RISK DIVERSIFICATION ALPHA RISK GROUP INTEREST RATE RISK INFLATION RISK/PURCHASING POWER POLITICAL RISK EXCHANGE RATE RISK/FOREIGN EXCHANGE RISK COST RISK ASYMMETRY OF INFORMATION RISK TIMING RISK/MARKET TIMING CONCENTRATION RISK 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 LIQUIDITY RISK BLACK SWAN ASSET CLASS RISK TOLERANCE RISK PARITY (OR RISK PREMIA PARITY) PROFIT RISK RISK PROFILING SYSTEMIC/SYSTEMATIC RISK/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 3 X CONTENTS SECTION 1 AN INTRODUCTION TO THE LANGUAGE OF RISK X X X 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] 5 X SECTION 2 THE COMMUNICATION CHALLENGE X X 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