This is the sixth and final post in a series giving our response to the FCA’s Call for Input on how to apply behavioural finance to help people make engaged investment choices more comfortably and confidently, and what role regulations can play in helping that to happen.
The series highlights four broad areas where better application of behavioural-finance insights can lead to better investor outcomes.
This post covers applying behavioural-science insights to break down barriers to receiving investment advice.
The full series is:
- Summary
- #1: Failings of existing suitability
- #2a: Failings of non-existent suitability 1: behavioural capacity
- #2b: Failings of non-existent suitability 2: pension transfers, ESG, and adviser noise
- #3: Behavioural science applied to improving investor education
- #4: Behavioural science applied to breaking down barriers to investment advice
There are two types of barriers to comfortable and confident engagement with one’s personal financial situation.
There are barriers created instinctively from within. The financial world, and everything in it, appears complicated and scary, as a product of imagination, rather than reflection.
There are also barriers forged by the external forces of the financial industry. Walls erected out of jargon, shrouded in a mist of perplexing product choice, and a dangerous hole where help should be.
These two types of barriers are inextricably linked. The existence of external barriers reinforces the strength of the internal ones,which in turn incentivises exploitative practices. You can’t sell keys to unlocked doors.
The FCA’s Call for Input included questions about three main obstacles to improved retail financial outcomes:
- Barriers to simple investment products.
- Barriers to financial guidance.
- Barriers to effectiveness of simplified financial advice.
Each of these highlight an aspect of the current industry and regulatory approach that we saw when looking at the failings of investor education in the previous post in this series, namely: a focus on products over the humans that own them.
There’s very little point worrying about the nuances of a language while no effort is being made to teach anyone how to speak it.
Speaking a different language
The FCA asked: What are the barriers to firms providing simple investment products for consumers?
Most investors have a natural desire for narrative and familiarity to give them sufficiently emotional comfort for them to invest. Regardless of the simplicity of the investment product, this is a matter of the investor’s emotions and behaviours, not the contents of the product, and it is through this lens that solutions should be sought.
Simple investment products, by their nature, are frequently lacking in both narrative and familiarity. The narrative, such as it is, is often simply about the risk/return level of the investment. And familiarity is sacrificed at the altar of diversification (entirely correctly, but at a cost to the emotional pull investors feel to the product).
The exciting, or novel, or complex product will often have narrative and emotional advantages over the simple suitable solution. This entices many firms to provide more complex solutions than necessary. This is difficult to overcome entirely, but any efforts to build compelling narratives around simplicity, cost, and long-term suitability will help. For example, more refined profiling (including, for example, accounting for responsible-investing preferences, make it easier for the story of ‘right for you’ to compete with promises of higher returns.
Terminological issues also hamper the provision of simple investment products.
‘Simple’ investment products are bought and sold in a world governed by a glossary that is far from simple. If we are to hope that common investment terms are understood outside of the industry, inconsistencies within the industry need to be ironed out first.
The most pressing concerns are:
1. Risk and volatility are frequently confused. This leads to inappropriate measures of: a) the risk an investor is willing and able to take; b) the risk of an investment or set of investments; and c) how the two interact. I.e. it leads to mistakes all along the suitability chain, and ultimately unsuitable outcomes.
This confusion increases the incentive to provide more complex products that pander to short-term perceptions, rather than those that focus on simple long-term risk-return trade-offs. See more on this here.
2. Many terms associated with suitability are imprecisely defined and inconsistently used. If this were only the case with fringe phraseology, it would not be such a problem. However, confusion is arguably greatest among the core terms that determine every suitability assessment: risk tolerance, attitude to risk, risk capacity,capacity for loss, risk profile, suitable risk level, and so on.
While we don’t believe it is necessarily possible to arrive at a single clear definition for each of these terms (particularly when also considering international differences in usage) we do think it extremely important to note that differences in how these are interpreted permit a wide range of inconsistent practices to be followed and passed off as being similarly ‘suitable’.
In particular, the existence of the dual terms of ‘risk capacity’ and ‘capacity for loss’ had led to considerable confusion. It has contributed to: a) a dearth of robust approaches to the coherent assessment of these concepts (which should entail a quantitative combination of the myriad components of overall investor financial circumstances and how they affect the investors’ suitable risk level);and b) the excessive reliance on risk tolerance (willingness to take risk) at the expense of risk capacity (financial ability to take risk) in the assessment of suitability. This encourages a substantial underplaying of the role of investors’ continually changing financial circumstances in determining suitability.
Although we make no claims to the best allocation/use of specific terms, we do feel it vitally important to have clarity on the conceptual framework of what the component elements (that these terms are attempting to name) mean and how they fit together. One attempt to arrive at a very clear description of the various components of suitability (with our definitions and nomenclature) is given in New Vistas in Risk Profiling for the Global CFA research institute.
Financial guidance and the role of personalised advice
The FCA asked: What are the barriers to firms providing financial guidance services?
In answering this question, we are focusing solely on the role of profiling services.
In general, there is a lack of regulatory clarity on where the boundary is between advice and guidance, and what that boundary means in practice.
For example, we often get approached by firms wishing to incorporate psychometric assessments of consumers’ financial personalities with a view to better ‘guiding’ them to becoming better investors, through improving their self-knowledge.
However, there is inevitably a nervousness around whether any personalised assessments, even where not linked to specific investment product recommendations, might not be construed as advice, and all the additional regulatory consequences that entails.
This is particularly true for the assessment of risk tolerance.In what circumstances might identifying an investor’s long-term psychological tolerance for risk constitute a personal recommendation? This is exacerbated by the tendency to conflate investor risk tolerance with the overall risk profile(or suitable risk level) of which risk tolerance is only one component.
Straightforward advice and better investment decision-making
The FCA asked: Do you think straightforward financial advice can help consumers make effective investment decisions?
Our answer is ‘yes, but…’
While almost always welcome, there is a great danger with attempts to make things especially ‘straightforward’ or ‘simple’ – they end up shooting past simple and ending up in simplistic.
In financial advice, this most commonly materialises as giving advice to an investment, rather than the human that owns it. All advice should be straightforward… and holistic. It is practically impossible to give‘suitable’ advice without some sort of holistic assessment of financial circumstances.
Straightforward should not mean simplistic. In particular,much advice is given under the rubric of ‘simplified’ or ’restricted’ advice, where the focus is on a single pot of assets and much relevant information about the investors’ overall financial circumstances is not considered.
This leads to more straightforward, but not more effective,investment decisions. In our experience, advisers frequently opt for simplified/restricted advice because of: a) a fear of higher regulatory scrutiny if they provide holistic advice; b) a lack of clear regulatory direction on how to assess and incorporate risk capacity in a scalable, quantitively measurable framework for suitability; and c) a lack of tools and technology to facilitate it, leading to even greater reliance on human subjectivity.
This is compounded by the occasional desire for advisers to offer investors a compelling narrative about how their advice and investment solution is unique and different to that of everyone else, leading to increased complexity at the expense of straightforward advice.
Holistic advice requires solid tools to rapidly elicit all relevant information and to combine it into an adequate assessment of risk capacity,which is often neglected in favour of the more easily measured risk tolerance.
In addition, there is far too much variability and subjectivity in how a given set of customer circumstances are combined to arrive at suitable advice (see the points on ‘adviser noise and inconsistency’ in part three of this series).
Finally, straightforward advice can help only if it is perceived and packaged as straightforward. The underlying conceptual framework should be as simple as possible, but no simpler. But if the presentation of this straightforward answer isn’t easily assimilated and interpreted by the investor, even the straightforward solution will still be seen as dauntingly scary: the worst of both worlds.
As with every other answer in this series, improving the consumer investment market starts with the consumer, not the product, and remembering that the consumer is a human, not a robot, or a zombie.
