By: Paul Nixon, head of technical marketing and behavioural finance at Momentum Investments and Greg Davies, expert in applied decision science at Oxford Risk
There is little doubt of the value that financial advisers add in getting clients to accumulate, protect and ultimately distribute their wealth.
However, financial planning is a professional service. And professional services involve judgement, which by its nature will be affected by inconsistencies.
Humans are prone to ‘noisy’ errors – unduly influenced by irrelevant factors, such as their current mood, the time since their last meal, and the weather. This chance variability of decisions is called ‘noise’.
Noise is negative both from an advice and an investment management perspective – particularly when you are focused on delivering the best possible solution for clients’ needs.
Momentum Investments are pioneers in South Africa with the outcome-based investing (OBI) philosophy that strives to create repeatable and consequently more predictable investment outcomes for clients.
From an investment perspective OBI is all about maximizing the probability of delivering a targeted outcome within an appropriate risk budget. The focus is on making fund returns less ‘noisy’ and therefore more likely to deliver on the targeted outcomes. All possible sources of investment returns and risk diversification is systematically evaluated: we look at different asset classes, alternative investment strategies within those asset classes, and negotiate the most appropriate mandates with the best investment managers available to deliver on these strategies.
The combinations of these mandates, strategies and asset classes are driven by the desire to minimise the negative effects of short-term fluctuations in returns on the ability of clients to achieve their investment goal. Managing ‘noise’ is exactly what OBI is all about.
But OBI is only half of the equation – more consistent investment outcomes paired with inconsistent advice due to ‘noise’ may still lead to a variable client experience.
Inconsistencies – The most suitable investment solution for a client should differ based on the client circumstances it’s recommended for, not the financial adviser that’s recommending it. The two main sources of inconsistency in advisory processes are an overreliance on humans, and the heavily front-loaded nature of suitability assessments.
The aim is not to turn financial advisers into algorithms. Humans are wonderful at many things, but they are unreliable decision makers, especially where many moving parts are involved – as in risk capacity.
Upfront assessments are necessary but insufficient, and often overplayed. Suitability reflects circumstances, and circumstances change. Because this is inherently complex, we are drawn towards keeping the status quo. Overemphasising initial assessments makes investment solutions over-fitted to the client’s circumstances at that single point in time, and unresponsive to subsequent changes. They drift away from what is suitable over time.
Risk Tolerance – an individual’s willingness to take risk – is a single, largely stable, and easily quantified attribute, and therefore regularly weighed too heavily in determining suitable solutions. Suitability should be more responsive to Risk Capacity – an individual’s ability to take risk – especially during an investment journey.
But Risk Capacity has many moving parts. Studies on multi-attribute decision-making show that even when people think they’re assimilating evidence from all sources, they’re really just filtering down to the few that stand out. And that few isn’t consistent over time, let alone over different decision makers.
Establishing frameworks to drive consistency in diagnosing situations doesn’t mean giving every client the same answer. It means those answers need to be within boundaries defined by a clear diagnosis of the problem. There are multiple paths towards remedying any situation, depending on client personality, circumstances, and engagement.
Identifying noise isn’t about eradicating inconsistencies. It’s about eradicating unjustifiable ones and evidencing justifiable ones.
As an industry initiative, Momentum Investments has initiated a project with the prestigious Oxford Risk in the UK and The Financial Planning Institute of Southern Africa (FPI) to shed some light on inconsistencies in the advice process and work together with financial planners to provide some guidance. The results of a formal study that is CPD accredited and recommendations on how, as an industry, we can create even more value for our clients will be published in the coming months.
Consistency of financial advice is a crucial concern, especially when we remember that advice isn’t a single event, but an ongoing relationship, and that the regulations care not whether you get it right on average, but whether you get it right for each individual.
Volatile markets, uncertainty and unexpected events, like COVID-19, will come and go. What is more important is that your actual long-term financial plan is sound and free of as much ‘noise’ as possible to focus on what matters – staying invested and focused on long-term goals.
All the expertise, products and service to help you to keep your clients focused on the destination.
Momentum Investments is part of Momentum Metropolitan Life Limited, an authorised financial services (FSP6406) and registered credit (NCRCP173) provider.