Maximum gain from minimum risk

IT HAS been acknowledged in the financial services industry that nearly all of the problems in retail financial services are the result of poor communication of risk. What a financial adviser would deem to be a medium risk is not necessarily what a client would accept as a medium risk. Whereas a financial adviser understands risk, most clients do not have the same degree of understanding.

Historically, financial advisers ask clients risk questions such as: "Are you a low, medium or high risk-taker?" The client's perception of risk will often be clouded by the success or failure of their previous investments in various sectors of the stock market.

Harry Markowitz, professor of economics at Harvard University, won the Nobel Prize for Economics for his work on what makes investments perform and he is credited with being the father of Modern Portfolio Theory. He discovered that 92 per cent of the success of an investment is in the asset allocation choice for the degree of risk that a person is willing to assume. The UK insurance industry has recently put emphasis on asset allocation tools to help advisers create portfolios with the correct percentage of shares, property, fixed interest and cash, depending on the timescale of the investment and whether income or growth is required. The other fundamental input into these computerised asset allocation tools is risk. Most of the insurance company-based tools require that the financial adviser know the risk and input this into the equation, but do they?

To make computer-based asset allocation tools meaningful, financial advisers must use sophisticated risk profiling tools to explore deeper into the client's understanding of risk. I, for example, use a risk profiling questionnaire which consists of 25 questions that "drill down" into finding out what real risk tolerance the client has, what losses they would find acceptable or not. By using this type of risk profiling tool, clients have a fundamentally better understanding of risk and it is their understanding of risk tolerance that we input into any computerised asset allocation tool.

It is vitally important that the client understands risk in their terms as each individual has a different concept of risk and reward.

The art of the financial adviser is to take the risk that the client is willing to accept and turn that risk into a range of properly researched funds that will give the client exactly what they want and give them a successful investment experience along the way without any sleepless nights.

? Max Horne is an IFA at Bates Millfield