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MiFID II Risk Profiles: Is it like hiking in the Alpine mountain trails?

MiFID II Risk Profiles: Is it like hiking in the Alpine mountain trails?

In this blog post I explore MiFID through ‘hiking trails’, ending with some reflections on loss aversion. I also argue that we are now only in the MiFID 1.0 era, despite its official name (MiFID II). MiFID will move from ‘compliance driven’ to something more meaningful.

To explain this further, for those of you who occasionally hike in the mountains, you may be familiar with ‘trail rating systems’, indicating their difficulty level. In Switzerland for instance, they range from T1 (very easy) to T6 (very challenging).

MiFID II is about offering suitable investment advice to retail investors. A crucial element of a suitable portfolio construction is determining the client’s risk profile. There are no clear, legally defined, risk profiles, but in practice between four to ten profiles are typically applied by financial institutions. For instance, ‘six’ different levels would be a good ‘average’. In that case Risk Profile 1 (R1) would be very risk averse and R6 highly risky.

The Swiss Trails

This summer, I was hiking in the Swiss alps with some friends. We chose a multiple day hiking trip in Ticino, the lesser known, but beautiful Italian part of this pristine alpine country. There is a color and rating system to inform hikers about the severity of the trail. For instance, red-white means you are ‘safe’. These are T1 – T3 trails. Whenever the trail color changes to blue-white, mind your steps. T4 – T6 are characterized by a need for mountaineering equipment (although it does not entail ‘true climbing’) and you are ‘exposed’. If you are like me and suffer from a mild vertigo, T4 is where it starts getting serious.

‘Exposed’ basically means that on some parts of the trail, a slip means a possible death, which can be compared to losing (all) your money (or not!?).

Before we return to the Swiss Alps, lets recap for a moment what risk profiles are under MiFID II. Without going into detail, risk profiles are basically determined by ‘combining’ your financial capacity and your risk tolerance. The apostrophes refer the fact that there is no accepted pre-described framework for combining a subjective and objective outcome. There is no straight mathematical answer.

A key block of MiFID is determining one’s risk tolerance. A number of questions (in practice they range between 5 and 120!) are asked to the clients to gauge their risk tolerance. There is no specific guideline provided by MiFID on how many questions need to be asked, however there are a few observations on the recommended approach:

  1. The more questions, the better insights, provided the right questions are asked
  2. Right questions imply consistency and accuracy (how do you measure that?)
  3. The questions should not be too few or too many, determining the number of questions is also important. Five are too few and 120 are too much
  4. Are all the answers actually used in the portfolio construction? Really?
  5. Does a ‘dynamic’ approach make more sense? E.g. should follow up questions take into account previous answers, social media information, etc.?
  6. Or I am implying that after ‘this’ MiFID a second and third generation will follow?

Often these questions are not scientifically underpinned (unless in countries like the UK, Canada, where companies like Oxford Risk Management and others have since long developed scientifically tested questionnaires), and furthermore…many of the answers are not really used in coming up with a ‘suitable’ advice. Not when the assessment is done manually or when algo’s of robo-advisors are used. But let’s forget about these reflections in the context of this blog. And let’s assume that there is out there a ‘correct’ way of assessing someone’s risk tolerance. MiFID II added or sharpened one particular element of that assessment, i.e. loss aversion. If you are like most people, you prefer to avoid losses rather than looking at the potential gains that you could make with respect to the similar risk. Ex ante that is… Most investors don’t like a bumpy ride.

Prepare before starting your hike Mountain guides will check – if they are any good - at the beginning of a guided hike whether you have done this before, how long, which difficulty level, what your physical capabilities are, etc. They will gauge whether you like balancing on a ridge or if that prospect would scare the hell out of you. The good ones will also check your boots. Hiking in the mountains is different than running on a flat forest trail and most of us need some extra support for the ankles. We are not all Kilian Jornet who seems to fly over the rocks at breathtaking speed.

The regulator – with good reason – wants to ensure that an investor has the financial means to invest and that he/she doesn’t suffer (too much) when that investment goes sour. They want advisors to understand the financial capacity of their clients.

The problem is that there are no clear guidelines how financial institutions should calculate this. Sure, MiFID refers to income, expenses, assets, debt, and future liquidity needs.

Suffices here to say that ‘determining your financial capability’ is (should be) an objective assessment. Either you can take the potential loss or not. Yes! I oversimplify here. Oh...of course there is a dynamic component to this. Hopefully your financial capabilities go up over time and not the other way around. But then and when are lifetime events like job loss and divorce factored in?

MIFID requires that the advisor also checks your knowledge and experience to avoid you invest in something – or you are advised to invest in something – that you don’t understand. Assume you ‘pass the test’. There is no concrete guidance or description whatsoever on how to combine the ‘objective’ outcome of your financial capability and the subjective outcome of the risk tolerance assessment into a risk profile, but let’s apply some common sense and agree that such a profile can be reasonably determined.

The Alps Analogy

Now we are getting closer to our alpine trail ranking system. Risk profiles can vary from ‘very risk averse’ to ‘risk takers’. And anything in between. A highly risk averse investor may get for instance a bond and cash containing portfolio recommended. Although it is way too simplistic to differentiate a risk profile alone on the equity/bond/cash percentage, typically higher risk portfolios will contain a higher equity component. The highest risk categories could arguably even contain some derivatives and why not investments in startups (which is very high-risk capital).

The latter can only be done – should only be done – with money you can ‘miss’. Remember our loss aversion element. Of course, what you can afford to lose depends upon what you are comfortable with, psychologically (subjective) and financially (objective).

The Swiss T1 trail is our lowest Risk Profile, let’s compare it to R1. We want to grow our money a bit via some very safe investments over perhaps a very long or shorter period of time. Time horizon is another key parameter entering the equation. Same for the trail. Even if you are hiking an easy route because you don’t like ‘exposure’ or ‘klettering’, you can still opt for a long six hour plus hike or a more pleasant one-hour walk (let’s not call that a hike anymore).

The Risk Takers, ending up in the highest risk categories (R5 – R10) go for higher returns (higher mountain kicks). Of course! Why incur risk without the possibility of a much higher reward. Or huge loss…. Hey…there is no free lunch remember.

High Risk Takers?

Wait a minute… Is a high-risk taker in the ‘physical world’ also by definition a high-risk taker in the money world? Here is where it gets confusing even when hearing what the experts have to say.

My personal view is that there is not necessarily a positive correlation. For sure there is no concluding ‘evidence’. We will definitely dig into this deeper going forward but just looking at my personal situation. I have so far only invested in stocks, a few ETFs and derivatives. Never in bonds and never in mutual funds. So, by definition, without fulfilling the MiFID questionnaire, I would end up in one of the higher or highest risk profiles. Perhaps my financial capacity would take me down a notch. So, a R6 – R10 let’s say. And although I, love sports, I don’t like things like bungee jumping or delta flying or…hiking T4 – T6 trails.

In the July 2018 edition of Swissquote, there was a very interesting article about neuronomics, which is an interdisciplinary approach using neuroscience, economics and psychology. In an interview with the ‘father of neuroeconomics, Paul Glimcher, he states that the potential ‘link’ between financial risk taking and ‘other risk taking’ is a very controversial one:

Clearly, I kind of disagree with the latter. It reminds me again of my recent summer trail with my mountain guide friend. For him even a T5 is like a walk in the park. But he would never invest in stocks!

The difference between T4 and the ‘lesser’ T’s

We are back in the Swiss Alps. Most of your life you have – assuming you like to hike or walk – hiked <T4 trails. The red/white ones. Not always easy…the Swiss seem to have a different idea of easy from what we have e.g. in Belgium. But in general, although sometimes long, steep and challenging, by and large ‘doable’ and seldom ‘exposed’.

The difference between T4 and the ‘lesser’ T’s

I love the mountains and hiking, tour skiing etc. but have admittedly some fear of heights. Always looking for endurance challenges, I tried to stay away from these blue/white trail paths, until this past summer. A good friend and mountaineer had put together a gentle (his words) hike of four days. Only the third day would be a bit more challenging he said. Turns out it was a T4 (piece of cake still for the ‘real guys’) but highly challenging for me. ‘Exposed’ got suddenly a different meaning. It seemed we were centimeters (not meters) away from a very steep and undoubtedly deadly fall in case of slipping away. It also didn’t help that the evening before there was heavy rainfall and the long green tasty grass covering the narrow path didn’t help either. The trail went basically for a few kilometers around the mountain range including waterfalls and huge rocks before we got the part where the steep climbing begun. I was so concentrated not to slip and didn’t enjoy at all the hike so much.

The difference between T4 and the ‘lesser’ T’s

Ex Ante and Ex Post

Arriving in a charming mountain village. It suddenly appeared when we came out of the forest, where we had struggled with a steep descent next to a ravine.

From one moment to the other around a corner…the alm appeared and then the village. Difficult became easy.

“So…was this trail really so heavy for you?” asked my friend. Well…now we were safe in the village, enjoying a late August sun, seeing the villagers prepare for the celebration of one of the saints, it all seemed easier. Jesus…if I had known that….

Ex ante, when people are confronted with ‘loss aversion’ questions, are they knowing themselves well enough? First of all, the way the question is asked is crucial. For instance, as XYZ points out, asking if someone can bear a 10% loss versus asking how he/she would feel if losing 100.000 EUR on a 1 million EUR investment leads to different results. Few institutions (on continental Europe) use psychometrically tested questions. Common sense is applied.

Let’s assume the right questions are asked. Let’s say that my mountain guide friend was able to gauge that T3 was my real comfort level and that T4 would be a stretch. Let alone T5. Ex ante, I would be pleased. A challenging but doable hike. Ex post? This downed on my when I did embark on the T4 and ex post realized it was stretchy but doable. And highly rewarding. And next time (ex post) I knew that there would only be one difficult stretch on this hike. Ex post I would know that I just needed to hang on a bit longer and all would be fine, and I would actually enjoy it. Ex post I am happy I went for the stretch. My reward was so much higher…

A slightly different take on trails and ex ante and ex post differences were recently described in an excellent issue of the National Geographic. They argue they are basically three types of hikes leading to three different experiences:

  1. Fun to do and fun to talk about after
    like a weeklong hike in the winter in Lapland but staying in cozy huts with sauna instead of tents -
  2. Not fun to do but fun to talk about after (hard but nice)
    like a 2-week mini expedition in Svalbard with pulka and cross-country skis and tent -
  3. Not fun to do and not fun to talk about after
    like a long horizontal stroll witty too many other people

MiFID requires ‘suitable’ advice. Although I have no proof for this it seems like the risk and compliance people are (sometimes gently sometimes not so gently) pushing towards the ‘safe side’. The regulator as well. And of course, we don’t want a reputation of the ‘The BIG CRISIS’. Of course, the spirit of MiFID is correct.

But I dare to question whether ‘enough risk‘ is taken. Am I now cursing in the church? Perhaps…but people or society at large tend to overcompensate.

But how many people lost exactly ‘what’? The stories that emerge are single stock investments in certain popular (banking) stocks. Surely most advisors worth their salt would have advised against single stock investments?

But I hear many other stories as well. Those stories go amongst the lines of:

  • “I feel ripped off by the high and non-transparent costs.”
  • “I pay a huge fee for what?”
  • “My savings account had a higher return than my fund investments.”

The other day I was looking at the private banking statement of my wife’s family. It was a ‘bond-only’ portfolio with at least 30 lines and an overall annual return of around 2%. Add to that a totally non-existing digital experience, huge fees and custody fees on top of it. This is crazy:

  1. A bond only portfolio covering the last 20 years is… (you fill in)
  2. 30 lines….??
  3. Sky-high fees
  4. 2%? Are you kidding me?

There is no way this is ‘suitable advice’. Yes, they didn’t lose their money. But the feeling of being ripped off is clearly there and the opportunity cost huge. Imagine a robo-advisor service which actually does use the input on questions asked and is able to estimate a more appropriate risk profile, the likelihood is high that at least a 3 – 6% return would have been achieved. Start calculating compounded interest over 20 – 30 years…

Concluding Thoughts

  1. MiFID is a great philosophy…. but the practical implementation has room for improvement for much deeper (scientifically supported) insights over the coming years
  2. Just like a T4 is not for everybody the same, risk profiles depend significantly (entirely) upon the right profiling
  3. Ex ante and ex post are indeed two different things
  4. Ex post… one can think… should not have I gone for a T4… Have I challenged myself enough? Did I take enough risk?
  5. Private banks as well will be significantly challenged and will need to enter the digital and more transparent era. The private banker will always remain an important person.
Concluding Thoughts

Bart Vanhaeren
Bart Vanhaeren
CEO and co-founder