Don't be chicken when it comes to talking about risk

Graham Bentley, head of investment marketing at Skandia, believes that the losses recently incurred by investors has highlighted the need to be perfectly clear on what risk means

In any market, the importance of matching investments to a client's attitude to risk remains paramount. However, discussing the concept of gain and loss can prove difficult for advisers and clients may not fully understand the risks they are taking. Documenting this discussion is essential and advisers who follow a robust risk-profiling process will have clients who are prepared for both the gains and the losses made and who ultimately are happy with the service they receive.

A short anecdote gives insight on how the human brain reacts to positive and negative consequences. My wife recently persuaded me to invest in a pair of chickens - live ones. The chap who delivered the birds assured me that a simple shake of a plastic cup containing dried maize every time we were about to feed them would quickly establish a signal - after a week that sound would be sufficient to bring them running from wherever in the garden they happened to be rooting. True enough it worked; they had learned through what psychologists term ‘reinforcement learning.'

The shake of the cup becomes the signal for a treat, which is reinforced every time they hear the shake; thus an association between a behaviour and a consequence is formed. From a psychologist's point of view, there are four possible consequences to any behaviour:

• Something good can be offered
• Something good can be withdrawn
• Something bad can be offered 
• Something bad can be withdrawn

In this somewhat simplistic world (if I were so inclined), a signal associated with a punishment could be introduced were the chicken to peck at the petunias - gunfire, for example. Now as with animals, humans learn to choose responses associated with producing favourable outcomes (one and four) and avoiding unpleasant ones (two and three). The theory predicts that behaviour which avoids negative outcomes should rapidly disappear in the absence of explicit reinforcement; in fact, studies show that once an animal manages to avoid punishment, it will continue to avoid what caused the punishment, even when it never experiences negative feedback again.

In a 2005 study researchers scanned the brains of humans performing a simple task, focusing on an area of the brain called the medial orbitofrontal cortex, which has been linked to reward-related stimuli, particularly when the reward involves money. The results showed that as far as brain activity is concerned, avoiding negative outcomes and receiving rewards amount to the same thing for the brain: achieving a goal.

Reward serves as an external signal that reinforces behaviour associated with a positive outcome, while punishment amounts to an intrinsic reward signal that reinforces actions linked to avoiding bad outcomes. In other words, the presentation of ‘something good' (eg long-term positive investment returns) alongside the presentation of ‘something bad' (eg potential losses) makes it extraordinarily difficult for a prospective client to make an investment decision. In this instance, the client is likely to feel more comfortable with something bad, such as the potential loss, being taken away and may focus solely on the good.

A reaction to this client behaviour is alluded to in the recent annual review for 2008/09 from the Financial Ombudsman Service (FOS). Consumer complaints about investments have almost doubled in the past year, according to the review. After allowing for an expected rise in complaints that are purely about investment performance, which the FOS has the discretion to ‘dismiss,' the report claims that difficult stock markets can expose poor advice and sales - for example, where customers who were willing to accept only a low risk to their capital ultimately find they have actually invested in a higher-risk product.

In these circumstances, the FOS says: "We have to look carefully at the circumstances of each sale, to ensure that the product was suitable for the consumer at the time the investment was made...we examine ‘suitability letters' or reports issued at the time of sale, to see how clearly any risks were drawn to their attention. If we decide that warnings were inadequate - and that the product appears to be of a higher risk than the consumer was willing to accept - we may conclude that the sale was unsuitable."

Furthermore, the review has underlined the importance the regulators have placed on how clients' risk tolerance is assessed, ie the potential for losses and the likely consequences regarding their long-term expectations: "An investor may have been identified as willing to accept a medium degree of risk, in the hope of a medium degree of growth. But in the complaints we have seen this year, advisers have not always considered the consumer's ability, or willingness, to absorb a corresponding decline in values."

As discussed earlier, it is difficult to present loss and gain in the same sentence so as to receive a cogent response from a potential investor. Where incentives to a salesperson are directly linked to the investment being promoted, it is difficult not to play down the ‘something bad' and underline the ‘something good.' However, this is not the issue for a professional financial adviser whose earnings relate to time, and ultimately to client satisfaction. Whatever risk-profiling tool used, an adviser still needs to quantify the risk in something other than subjective terms; words like ‘balanced' or ‘cautious' are at best naïve and at worst dangerous to both the client and the adviser's business.

How does an adviser inform the investor of the likely gain and loss associated with a particular fund or asset allocated portfolio? Just what does ‘risk level X' actually mean? Investment returns can be expressed in terms of variability of loss and gain. This information is readily available given sufficient data and is known as value at risk. Returns can be exposed as extremes of potential gains and loss, to a prescribed degree of confidence (usually 95% or 99%).

Most importantly, when clients see the potential downside they may decide that the possibility of loss, however remote, carries such a potential impact (eg failing to meet school fees payments) that they need to look for a lower-risk option - one that carries less potential distress, despite the lower potential returns that they might experience on the associated upside. This requires reference to the goals the client has expressed on their fact find - how would they feel if those goals were not achieved? Recording this course of action produces a clear audit trail of the decision-making process.

Discussing a potential loss should not be avoided. As Sam Walton, co-founder of Wal-Mart describes, clients are the advisers' life blood: "There's only one boss - the customer. And he can fire everyone in the company from the chairman down, by spending his money somewhere else."

Advisers need to be straightforward and transparent - the client will be more comfortable, and will ultimately thank the adviser for it by staying loyal and recommending new investors to the business.

Do not be chicken when it comes to talking about risk.