Advisors Acknowledge Investors Cannot Fairly Evaluate Risk

In a survey of 50 advisors, and investment councilors from firms across Canada, advisors were asked two questions: ‘What percentage of your clients know the odds of losing money in their investments over the next year, and if there was a chance they could lose money, would your clients know how much money they could potentially lose?’ In 49 out of 50 interviews the answers were candid and surprisingly similar. Most investors cannot fairly evaluate the risk of their investments.

Hans Merkelbach, an advisor with Dundee Private Investors, well known for his outspoken support of disclosing accurate return and advisor compensation information to investors stated “I try to educate by regularly sending articles and letters to show clients what I’m trying to accomplish in their portfolios, but most clients could not answer those kinds of questions with any certainty.”

In a recent study conducted by Desjardins and published in the Investment Executive’s Special Supplement November 2005, almost 60% of surveyed Canadians believe they have limited or no knowledge about retirement savings or investments. The general consensus of the survey of advisors conducted by PureLogix Corp. in October of 2005 suggested a much lower number. According to advisors, perhaps less that 10% of investors have a clear picture of the risks they are exposed to.

These findings are partially confirmed by the Investment Dealers Association website. As of September 30, 2005, 1015 complaints had been received for the year. Out of all complaints received the IDA lists ‘unsuitable investments’ as one of the most commonly reported investor complaints. Although the IDA does fine a large number of advisors each year, the number of fines issued is a fraction of complaints received.

The discrepancy suggests the majority of advisors are filling out Know Your Client data adequately to satisfy investigators. If that’s the case, the only other reasonable conclusion that can be drawn is that complaint numbers are driven primarily by investor misinterpretation of risk.

Gamblers can easily find the odds of winning or losing a game of chance posted within casinos. Poker played on television calculates the odds of winning a hand in live time for the education of viewers watching the game. With something as important as investor life savings, why aren’t dealers providing tools to the advisors in the field to accurately disclose risk to investors?

Advisors interviewed cited many issues. First, the majority of investment dealers and investment council firms may not have the finances or expertise to develop adequate proprietary in-house systems. Second, there is a problem with awareness. Many dealers don’t realize excellent risk assessment technology can be purchased ‘off-the-shelf’. Others felt governance requirements were at the root of the problem. One advisor who asked not to be named said, ‘If investors aren’t demanding this kind of disclosure, then regulatory bodies aren’t interested in pursuing the issue even if it is the right thing to do.’

What can advisors and investors do to better understand the risk of investments if they don’t have access to software that calculates risk for them? Go back to your high school math text books and start applying basic statistics to evaluate risk. Using only a three year time-weighted return, a three year standard deviation and a basic calculator both advisors and average investors can start to get a better understanding of risk. Here’s how:

The basic premise when considering standard deviation is the bell curve. It’s not really important to know what the bell curve looks like or exactly how it’s calculated. What is important is knowing the statistics surrounding it. One standard deviation away from a security’s average return (known as the mean return) accounts for around 68% of all one year returns sampled in a three year period. Two standard deviations away from the mean return account for roughly 95% of all one year returns sampled in a three year period. Three standard deviations account for about 99% of all possible returns.

Let’s say for example, you are evaluating a security with a 10% 3-year compounded return with a 3-year standard deviation of 8%.[1] If a security’s average return is 10%, one standard deviation, or approximately 68% of the time an investor could expect the security to return a one-year return of between 10%+8% = 18% and 10%-8% = 2%. If we include 2 standard deviations, then 95% of the time an investor could expect the security to return a one-year return of between 10%+8%+8% = 26% and 10%-8%-8% = -6%. The remaining 5% of the time is where it gets a bit more critical. There is a 2.5% chance this security could produce a one year return in excess of 10%+8%+8%+8% = 34% or more. There is also a 2.5% chance this security could return 10%-8%-8%-8% = -14% or more. Admittedly, a 2.5% chance of losing 14% or more in one year is remote, but if an investor isn’t absolutely prepared to lose 14% or more of their life savings in one year, they really should be given the opportunity to ask their advisor to present a more conservative solution.


[1] Please note, that although the 3 year compounded return is not the mean return for the security, it is usually much easier to find than a three year mean return, and will suffice for rough evaluation purposes

Trade Compliance In Canada - Too Reactionary To Protect Investors?

Are investors being properly informed of the risks associated with their investments? A quick review of the IDA website confirms both compliance officers and the firms they work for regularly show up in violation of IDA Regulation 1300.2 – Improper supervision. Although advisors (and indirectly the firms they work for) are hired by investors to help guide investment decisions and increase awareness in the products being purchased, it seems clear: too many investors end up not understanding the risks associated with the investments they are buying.

According to ComSet (a database built to receive and store client complaints, disciplinary matters, internal investigations, disciplinary actions, settlements, and civil, criminal or regulatory action against the firm or its registered employees), in 2003 there were 2670 events entered. Of those, 1936 were customer complaints, and 1249 complaints were specifically concerning unsuitable investments. This means nearly half of all ComSet events, or over 60% of all customer complaints are unsuitable investment complaints. In 2004 there were 1896 events entered. 1276 were customer complained, and unsuitable investments made up 776, or over 60% of all customer complaints.

With approximately 24000 registered IDA members, one would have to assume that between 3 and 5% of all advisors may be facing at least one unsuitable recommendation complaint at any given time. Even more worrisome, with 629 civil claims in 2003 and 500 civil claims in 2004, perhaps as many as 25% of all unsuitable investment complaints may actually be turning into expensive, drawn out civil claims. With the recent push from regulators to firms in an attempt to help smaller investors recoup losses from ‘rogue’ advisors, the number of complaints turning into fines could rapidly increase

At the root of this problem is the reactionary way many compliance departments are forced to deal with potential trade supervision problems. When it comes to assessing risk, investors, advisors and compliance departments are often not reading from the same instruction manual. Although an investor might sign an account opening form confirming they are 100% ‘medium’ risk, what ‘medium risk’ means to the investor, advisor and compliance department may differ greatly. In the absence of a solid representation of risk, investors are being forced to use their past investing experience as a guide. In this type of scenario the results are predictable; advisors and compliance departments often end up using signed investor documentation to defend themselves and the firm from litigation rather than to protect and educate the investor

To compound the problem, when an inappropriate trade is detected in an investor’s account, the compliance department will order the advisor in charge to either reverse the offending trade, offset the trade with a purchase of a lower risk security, or ‘update’ the investor’s Know Your Client information. Many advisors feel reversing or offsetting a trade make them look foolish in the eyes of the investor. After all, the investor is relying on an advisor’s investing experience and product knowledge. Instead, it’s much easier for an advisor to say, ‘If you don’t want my firm freeze your account, you’ll need to sign this Know Your Client update.’ Simply updating the Know Your Client does not solve the problem. The updated Know Your Client might now match the compliance department’s assessment or risk, but in such a situation it’s hard to imagine the Know Your Client matching the investor’s interpretation of risk.

For the trade approval process to protect the investor rather than the advisor or firm, thorough risk return analysis of an investor’s proposed account must be presented in graphical or numerical representation that the average person can understand. Risk category percentages or account standard deviation summaries mean little to the average investor. When approving a proposed portfolio, investors should be confirming a proposed portfolio (at least historically) has achieved a return suitable for long-term investment plans, within a level of downside risk acceptable to the investor. It should be up to the advisor and the sponsoring firm to determine what the standard deviation of that proposed portfolio is, how that standard deviation number should translate into Know Your Client data, and most importantly to continue monitoring the account over timeto ensure performance continues within the limits originally agreed to by the investor

Even though there may be considerable training or technology costs associated, what’s clearly needed is a commitment by the industry to a more proactive version of the traditional trade approval process. The proper training and tools to measure risk, explain risk and accurately transcribe that risk tolerance information onto dealer paperwork must be provided to advisors if firms want to ensure the proper information is getting into the hands of investors. Without such change, policy concerning trade suitability issued from regulators or compliance departments will ultimately continue to fail.