Experts discuss risk – Part One

Reader Alert: This the first part in our two part coverage of a roundtable risk discussion with Canada’s foremost CFAs. For Part Two, click here. Click here for the ‘AE Risk Roundtable Photo Gallery’.

Clients witnessed risk in action in 2008, but have these lessons lingered?

Risk is a layered concept.

Individual investors—even high net worth clients—acknowledge their balance sheets.

Do they truly recognize the forces behind them or even their own risk thresholds at all?

Advisor’s Edge hosted leading Canadian CFAs and business experts to examine just how deep that understanding goes.

They also discussed how advisors can best present risk concepts to create truly informed investors.

Participating in the roundtable were:

• Margaret Franklin, chair of the Board of Governors of the CFA Institute.
• Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University.
• Stephen Copeland, senior vice president investments and private client services at Foyston, Gordon and Payne Inc.
• Tom Trainor, managing director of the Hanover Private Client Corporation.

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Advisors’ Edge: It’s often said that clients don’t really understand risk tolerance, or their own risk tolerance levels, until they actually experience losses. Is that true?

Milevsky: Quite a bit of research questions whether risk tolerance exists and whether it’s something that’s measurable. Hypothesizing about how they’ll behave under risky conditions and actually seeing their behaviour under risky conditions are very different.

Trainor: There is the financial capacity for risk and there is the emotional tolerance for risk. With financial capacity, I think clients have a relatively good idea of what they can withstand. But in terms of the emotional tolerance for risk, they don’t have an understanding at all. That’s what we saw in 2008 and 2009. People who were extremely sophisticated in the financial markets came to me and said, “I had no idea I would react this way.”

Milevsky: Part of the problem is that the questionnaires we’re using to ask about risk tolerance aren’t really capturing clients’ trust tolerance, primarily because it’s not about their experiences, it’s about their feelings. We have to differentiate between risk tolerance and risk capacity.

Franklin: The year 2008 gave us tremendous experience in risk. By the time people have significant wealth, most of them probably have had an experience in loss. One of the big lessons for the professionals is how to take what’s in people’s experiential data bank and draw that out so it relates to the investable portion of their financial portfolio.

Copeland: It’s like an armchair quarterback. Someone can sit in a chair and say, “I wouldn’t have made that play,” and that defines their internal risk tolerance. But risk behaviour changes when you actually have to invest, especially when faced with changing environments.

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Advisors’ Edge: What kind of anecdotes of risk experiences can you share? Everybody said they could take a 20% loss, for example, until it actually happened to them.

Milevsky: I don’t think it’s the 20%. They’re afraid it’s going to become 60%. It’s not that they can’t handle the risk, they can’t handle the direction.

Franklin: In 2008, we were looking at unthinkable events: Money markets had failed. Vehicles that were supposed to be safe weren’t. The banking system wasn’t safe. So the imagination could run amok: 20 could go to 60 could go to zero.

Copeland: Trust played a strong role too. A few of my newer clients who didn’t have as much trust were saying, “Get me out.” And a few of my older clients, who had been with me a long time, said, “I haven’t opened my statements in six months.”

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Advisors’ Edge: Do you have other thoughts or anecdotes that explain client behaviour and risk?

Trainor: Often, clients have very little experience of being an investor. So advisors should be going back to basic principles. They should be telling them that certain risk-return parameters are driving the market, and every 40 or 50 years, the wheels are going to come off, but it’ll come back eventually.

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Advisors’ Edge: When you’re dealing with people like that, what are some of the things you’ve done to work with them?

Franklin: We take a classic conundrum approach, where you feel emotional about something and you try to sort through the problem. You write down the specific issues, the pros and cons of various solutions, and then try to drive towards the one that best meets the financial objective of the client and their emotional capacity.

Copeland: People forget about the upside to risk, especially when they’re faced with negative returns, which then results in conservatives moving to a cash strategy and keeping their money under the mattress. Risk is a two-edged sword, and they’re only concentrating on one side. It doesn’t matter whether you talk about objectives or long-term. For clients, it is, “What do I have in my portfolio today, and can I survive with that over the next 10, 20 or 30 years?”

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Advisors’ Edge: What percentage of clients actually understand their risk levels?

Copeland: Most people want last year’s return. Everyone seems to know they have to take risk to earn return, but they don’t want to take that risk.

Franklin: The CFA Institute is dedicating a lot of resources to behavioural finance. It’s not that people don’t have an appreciation for risk, but they don’t have the right tools or financial literacy to make optimal portfolio decisions. How do I know my assets are safe? What should I ask to make sure my advisor isn’t going to run away with the money?

Trainor: Until you actually have bullets flying by your head, you’re not going to know how you’ll react.

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Advisors’ Edge: How can you stress-test clients to determine how much risk they can tolerate?

Milevsky: My experience is with people at seminars. It’s not that they don’t understand risk. It’s that they don’t understand why things happen, like why stocks fall. Why should this particular asset class be correlated with that asset class? That’s the concern. This is a socio-economic issue. At certain levels of wealth, not only do they not understand risk, they don’t understand capital markets. And they don’t really understand the functions of an economy. So they have a severe handicap to overcome before we can educate them about capital markets and risk and return trade-offs.

Trainor: We spend an awful lot of time educating them about the markets and portfolio structure in a way that we think they can deal with. You might have an NHL hockey player who’s making millions a year but never made it through Grade 12, versus the CEO of a financial institution. The conversations are totally different.

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Advisors’ Edge: How do you manage that as professionals? It’s got to be difficult to keep changing the way you present concepts.

Copeland: I spent most of my career in bond portfolio management. And the concept of prices going up and bond yields going down, bond yields going up and prices going down, and then you throw in duration—forget it. You can use a teeter-totter as an analogy, but people still just nod knowingly. They think of Canada Savings Bonds, where there’s no concept of opportunity or risk. If rates go up, you have opportunity costs. But it’s very difficult to broach that with the average client, even ones who have some background in finance.

Franklin: Financial literacy has not been part of most people’s training. That’s critically important, because it’s probably not going to go back to a time when the state takes care of you, whether it’s the corporate or the political state. We’re saying, “Here are things you should ask your advisor, here are things you should be thinking about.” There are books that present difficult concepts. The Richest Man in Babylon is a wonderful book written in the 1930s and that takes place in Babylonian times, and the messages in the story are just as applicable today as back then.

Trainor: Six or seven years ago we recognized that 30% of CFA members are associated with private wealth.

Franklin: That’s where the big pools of capital are. It was institutional, and it’s migrating over to the individual investor.

Milevsky: The CFP designation is trying to go after this exact audience. I wish there was more co-operation between these two organizations with designations because they’re both after the same thing, which is to help individuals make better financial decisions.

Franklin: We’re going to have to do a much better job of walking in the client’s shoes as a recipient of our services and ask, “How do these people work together on my behalf?”

Milevsky: I see it among undergraduates. There’s a kid who’s trying to figure out what to do with their career, and they really like the idea of wealth management. So do they go through the three levels of the CFA, do they go for the CFP, do they go for the CLU? More co-operation would be very helpful so we didn’t have to pick sides.

Trainor: I agree 100%. Depending on the door that you come through, you get the solution based on that door, which may not be the optimal solution for the client. Some people will never see an investment counsellor recommending an annuity, even though it might be the right thing for the client, because they’re going to lose $1 million or $2 million in assets.

Milevsky: And vice versa. The insurance advisors don’t have the statistical training to recognize true alpha if it hit them in the face. Think of the next generation. People in their 20s are trying to figure out the avenue they should take. And it’s tough.

Franklin: You have to pick one of them. I actually think you do a disservice by saying you can be a generalist.

Trainor: There’s a role for all those designations. I’d say probably one of the best places to start off would be as a CA. Because of their tax capacity, their analytical capability and the different areas that they work in, it’s a great training ground.

Franklin: You have to have an area of specialization. You want to be really broadly aware of the other issues and how they relate, and how you’re going to co-ordinate them. But at the end of the day it’s the investments that are the variable and that change dramatically. Not understanding what makes up financial products is a problem, because then you can’t have the conversation with the client about where the difficulties and opportunities are going to occur.

Milevsky: When you talk about risk tolerance, are you willing to have a conversation with them about what the best mortgage for them is? They may have a $1 million mortgage on their property. So you’re managing a $1 million portfolio, but they’re trying to figure out fixed floating cap, long-term, short-term—are you willing to have that conversation as well?

Trainor: An analyst can determine what the optimal capital structure is for a corporation, and in the same way an individual also has an optimal capital structure. That’s one of the things we’re working on right now—how to model those.

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Experts discuss risk – Part Two

Terri Goveia