Risk profiling is an important part of the investment process. Before selecting the most appropriate investment strategy for a client, it is important to first of all understand their attitude to investment risk.
This basically means how much risk they feel comfortable taking with their investment fund.
The level of risk generally increases with the potential return (and potential loss). Whilst those investments with lower risk have an historically lower return, these tend to be more stable than riskier choices.
The graph below illustrates this with a comparison of performance of Emerging Markets equities v. Gilts over the period 2001 – 2015. The emerging markets (EM) investment return is much more volatile and investing in EM is higher risk compared to lower risk gilt investments.
The Risk Profile Questionnaire
When assessing a client’s attitude to risk we often start with a risk profile questionnaire, which I know from experience many clients don’t like. It’s seen as a chore by some and particularly when the questionnaire has to be revisited annually or following life events.
Completing the risk profile questionnaire is a vital part of the process and we cannot establish the suitability of investments without it.
Should you approach investment in the same way when you’re a few years from retirement compared to a 30 something parent or a younger professional?
What about if you have a lump sum from inheritance or retirement?
Your attitude to risk and resulting investment choices will change over time. That’s why it’s important to regularly revisit the risk profile and make sure investments are selected to suit your capacity for loss – more of that later.
The adviser role in determining your attitude to risk
Whilst attitude to risk is in part down to the personality of the client it’s important that this is considered alongside the expert view of an adviser. We don’t rely solely on the results of the risk questionnaire, and in many circumstances we determine a different attitude to risk following further discussions with clients.
Indeed, the Financial Conduct Authority (FCA) who regulate financial advice firms states that a “firm should take reasonable steps to ensure that a personal recommendation or decision to trade is suitable for its customers”. They require firms, amongst other things, to take account of a customer’s preferences regarding risk taking, their emotional reaction to volatility and risk, their risk profile and to ensure they are able to financially bear any related investment risks consistent with their investment objectives.
Over the years, our approach to risk profiling at LIFT-Financial has become more sophisticated. Not that we ever just relied solely upon a risk profile questionnaire as the be all and end all of investment advice - they were always considered alongside discussions with clients, but we can now use technology to develop our strategy further.
Your capacity for loss
So, what exactly is capacity for loss and how is it different from attitude to risk?
Capacity for loss refers to an individual’s ability to withstand financial loss, whereas attitude to risk is based upon their personal opinions.
An example of this could be someone in their 20s looking at investing in a pension who completes a risk profile questionnaire and comes out as cautious. Assuming they can afford to make the pension contribution, they have a fairly high capacity for loss because they will not be able to access the monies in their pension until at least age 55. Now this individual could have filled in the questionnaire having very little experience of investing and as a result this could influence their decisions when answering the questionnaire.
On the other end of the scale a client who is approaching retirement could complete a questionnaire and come out at moderately adventurous. In this case, the question I would ask is do they actually need to take this much risk? Have they achieved their objectives and is their retirement pot of sufficient size to facilitate their retirement? Even if it isn’t, if they are going to use the pot for income generation they should question whether they can actually afford to take this much risk.
Where do Objectives come in?
Establishing a client’s objectives is a key part of the discussions surrounding attitude to risk and capacity for loss.
If, for example, a client’s objective was to generate an income in retirement of £25,000 per annum and they have achieved a retirement pot of sufficient size to generate this income, I would be contacting the client to discuss their attitude to risk once again. If they have achieved their objective then they might not need to continue taking as much risk as they have in the past. Alternatively they might want to reassess their objectives and create an alternative suite of 'desirable' objectives, rather than the fundamentals previously identified. Of course, it would depend on how close to retirement they are.
How can we help?
The advances with back office systems and cashflow forecasting now means that we can use these systems to illustrate to clients how the results of a risk profile questionnaire can impact the expected returns from investments. In many cases we will use cashflow planning to show clients the impact of a severe market crash on their portfolio. Indeed when we do any forecasting of any kind we are always on the more cautious side when selecting the expected growth rates.
Back office systems can be used to record discussions about attitude to risk, capacity for loss and a client’s objectives and reminders can be put in place to regularly update these.
So do please bear with us when we ask you to complete these questionnaires.
It is the first step in a robust process to ensure that the investments we recommend are suitable for you. As I mentioned we will never use the outcome of the questionnaire without further discussions, and there are no wrong answers.