A broad and real view of risk

(June 2008) “At least you didn’t lose any money” is a phrase commonly heard when an investment product, acquired on an advisor’s recommendation or at a client’s insistence, does not perform as promised or hoped.

Principal protection, which is being discussed (and touted) by many in the financial services industry, is seen as a means of limiting potential liability when clients are reliant on the advice they receive from those professing to be professionals. Principal protection will leave the client “whole” — he or she will not have lost any money — but excessive steps to protect principal come at the cost of potential returns. Many regulators also seem to think that protection against loss of principal, measured in a nominal manner, is the primary obligation of financial advisors in many instances.

While protecting against the loss of principal can be supported in low-inflation environments in which principal recovery is not an easy task, particularly if the investor is reliant on interest income to fund this recovery, and minimizing risk of loss is a noble goal, it must be balanced against the real cost of being too conservative.

Concern about the potential for principal loss was embedded in various pieces of legislation that, in the past, governed insurance company investment portfolios, pension funds, and other organizations with liquidity obligations and fiduciary or contractual obligations to beneficiaries. The legislation imposed very strict parameters on these portfolios. The need to obtain greater returns, to offset in part the impact of increased inflation and taxes, led to the slow elimination of these rules from the books. Today, only those who have been in the industry for quite a number of years are familiar with the meaning of the phrase “legal for life.”

There are many instances of lawsuits launched by clients who found themselves with portfolios that were far too risky. I am not aware of any lawsuits or settlements to date resulting from overly conservative portfolios. Advisors are told to caution clients about overly risky portfolios, but there doesn’t seem to be any general practice to caution clients about overly conservative portfolios.

The dramatic impact that seemingly small differences can have on medium and long-term overall returns is, or should be, well known in the industry. I would argue that where a client avoids risk by investing in investment products with returns that are, in the scheme of things, rather low, the potential for liability is real.

If a portfolio’s positions are unsolicited, an advisor should caution the client, where appropriate, that avoiding risk comes at a price: lower returns that will likely have a material impact on his or her financial health in the future. If an advisor recommends an overly cautious approach over an extended period of time, a claim of negligence might be successful if those recommendations result in a portfolio that generates returns well below what would be generally seen as appropriate or expected for a client with a similar risk tolerance and time horizon.

In choosing an appropriate portfolio mix, many in the industry figure 100 less the client’s age is a good rule of thumb for determining the percentage of a portfolio that should be invested in equities. Aggressive or even moderate variance from this “rule” is seen as risky as it increases the risk of principal loss.

With inflation and additional cutbacks in “free” social and health services that will need to occur as the population ages and life spans lengthen, or as tax rates explode in the alternative scenario, overly cautious portfolios with limited growth potential will increasingly fail to meet the financial needs of older Canadians.

Growing old is tough, tough enough to make some people angry. Growing old without enough money because their advisors were too conservative in their recommendations can make clients especially angry.

Living on a fixed income that is declining in real dollar terms will help ensure these potential plaintiffs will be seen in a very sympathetic light by the courts. These plaintiffs might not have the money to sue, but their children, who face the burden of supporting parents with declining financial resources, may figure that fronting the cost of a knowledgeable litigation lawyer (or finding one that works on a contingency basis) is a good gamble. They may lose their principal on the bet, but the potential return is good, great even, if their parents relied on the advice of an advisor who, for fear of facing clients who suffered a loss of principal, on paper or otherwise, kept them in so-called low-risk investments over the course of a lengthy relationship.

Richard E. Austin is counsel with Borden Ladner Gervais LLP in Toronto, and specializes in financial services, with a particular emphasis on registration and compliance matters. RAustin@blgcanada.com

(06/16/08)