What does the word risk mean to most people? It is inevitably linked with the fear of loss, danger, suffering harm, uncertainty and death. So as soon as you ask a client about their attitude to investment risk that sense of fear and unease kicks in. I find this quite unhelpful and unconstructive when discussing a client’s attitude to investment risk. In fact, I find investment risk analysis to be totally inadequate. Let me explain why.
Clients typically complete a psychometric assessment of their attitude to investment risk by answering questions on a form. The answers produce an investment risk score typically on a scale of 1 to 10 with 10 being the highest level of investment risk and one being the lowest level.
The adviser then assesses the client’s capacity for loss. In other words, how much money can the client afford to lose without it adversely affecting their lifestyle.
The adviser then discusses the client’s attitude to investment risk with them and they then agree on the most appropriate attitude to investment risk grade.
The problem with such a system is that it is primarily an assessment of the volatility of the investment rather than true risk which is the risk of absolute loss of capital. So, if the investment is into EIS, SEIS, VCT *** or private equity for example then there is a real risk of absolute loss of capital. Whereas the risk of absolute loss of capital in an OEIC or a unit trust is extremely low and almost zero in practice. In the 60+ years history of the Investment Association no OEIC or unit trust has ever failed and lost the investor money (https://wealthandtax.co.uk/why-there-is-no-such-thing-as-a-risk-free-investment/).
Over 10-year periods equities outperform bonds and cash 90%+ of the time but over 20-year periods the outperformance of equities is 100%.*
As financial advisers, we are taught to diversify investment risk by advising clients to invest across different asset classes including equities, bonds, property and cash. Equities are generally considered to be medium to high-risk investments whereas property, bonds and cash are considered to be low to medium risk. If only life were that simple!
In the first eight months of 2022 UK government stocks fell in value by 52% whereas index-linked government stocks fell in value by 69%! Bonds are considered to be low-risk investments. Clearly, they are not.
The performance of bonds much like any asset class varies depending on what stage of the economic cycle you are measuring. All asset classes have periods of good and bad performance. What you can say is that different asset classes have different levels of volatility on average over time but that is not the same as investment risk. So generally speaking, equities are usually more volatile than property, bonds and cash. However, their investment returns are usually lower than for equities, especially over long-time horizons such as 10+ years.
So, what we should be measuring is clients’ attitude to investment volatility, not risk. It is a far more accurate description and is less likely to create fear in a client’s mind.
Assessing capacity for loss is also wanting. Let me explain why.
Clients who do not rely on their investments or pensions because they have sufficient other assets to draw on and/or high enough guaranteed income, really shouldn’t be assessed the same way as clients who are reliant on income from their pensions and investments. More often than not such clients can afford to lose all of their pensions and investments and be no worse off. Such clients could easily be assessed as risk grade 10.
There is a further argument that the client’s attitude to investment risk should be assessed on their total assets and not just their investable assets especially when their other assets such as a property portfolio gives them a high level of rental income. An attitude to investment risk analysis per se makes little sense.
So to summarise, the whole system of attitude to investment risk analysis needs re-vamping to come into line with the 21st century. You know it makes sense.**