In this exploration of the key issues, eValue founder Bruce Moss looks at the private investor's perception of investment risk and how biased person views affect individual perceptions of risk.
He believes that large falls (often temporary) in stock markets are given much greater attention than the steady (and normally irreversible) loss of real value due to inflation. Both are types of risk which need correct evaluation.
He says most investors have little real idea about what investment risk means beyond not wanting to lose money. Their main concerns are wanting to have enough money for a decent retirement or to pay off the mortgage or to provide funding for the education of their children or grandchildren.
He looks in detail at what investment risk means to personal investors and at Target Risk Funds and their uses.
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Risk, suitability and how to overcome the limitations of target risk funds
It is well known that people generally have very skewed perceptions of risk. Dramatic outcomes are given much greater attention than more frequent smaller calamities. A good example is people's perception of the risk of death resulting from motor bike accidents compared to domestic falls. The risk of dying as a result of a domestic fall is 50% greater than being killed on a motor bike. It is obvious when you think about the number of old people living alone but perceptions are at odds with the reality.
The private investor's perception of investment risk is subject to similar biases. Large falls (often temporary) in stock markets are given much greater attention than the steady (and normally irreversible) loss of real value due to inflation.
Investors frequently have no real notion of investment risk beyond not wanting to lose money. They have objectives, however, such as wanting to have enough money for a decent retirement or to pay off the mortgage or to provide funding for the education of their children or grandchildren. These objectives do not easily translate into an investment choice – certainly not one defined by the volatility of its annual returns. However, the volatility of annual investment returns is the way that the industry typically chooses to categorise the riskiness of the investment funds it offers.
Risiko or - "lost in translation"
Essentially the investment industry and its customers are speaking different languages when they talk about risk.
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The result of this breakdown in communication is unsurprisingly frequent disappointment on the part of investors.
The problem is that investment risk is hard to define until it happens and then the investor suddenly realises what he or she was worried about all along:
• "I lost some of my capital when I sold my investments", or
• "My investments were not enough to pay off my mortgage when I retired", or
• "The value of my investments has been eroded by inflation" or
• "I didn't realise that the income I have drawn each month was seriously depleting my capital", or
• "I couldn't sell my investment easily when I needed to."
These are just a few examples of the risks investors face. There are many more. However, the crucial point is they are all potential unhappy events which affect the investor's wellbeing. Volatility is not an event and has no direct bearing on the risks that investors face. It is a convenient measure which is widely used in the financial services industry but is virtually meaningless to the private investor.
Because of this general failing by the industry to communicate risk effectively to investors, advisers can find themselves exposed to investment risk being defined retrospectively when things have gone wrong. It is a poor defence to tell low risk investors that their fund had low volatility when the income they have been advised to draw is not sustainable because their capital has been eroded. By the same token, investors who have taken high levels of risk to achieve long term goals may have good grounds for complaint if they suffer substantial capital loss if they don't stay the course. The issue is whether they were adequately warned of the extent of the risks they were running. Without good supporting evidence that they were, the Financial Ombudsman Service frequently has little option but to agree that compensation is due.
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Ensuring suitability – bridging the communications gap
The FCA/FSA's Guidance Note of March 2011 on establishing a customer's risk tolerance and the suitability of an investment recommendation identified a number of serious shortcomings in the processes of many advisers. While the FCA/FSA's analysis was generally good and extensive when it can to its review of risk questionnaires, it offered little help on the most difficult issue which was how to ensure that investment recommendations are suitable. This "hot potato" was left for the industry to work out for itself.
In response to the FSA's Guidance, increasing importance has been given to risk profiling and asset allocation in recent years. Many advisers pay a lot of attention to determining a client's risk profile and have developed views about 1) the types of questionnaire and 2) the balance of questions to use (e.g. investment experience and knowledge vs. psychometric profiling). In short, a lot of time, energy and science are being applied to try to get an accurate fix on an investor's attitude to investment risk.
But once a client's risk profile has been determined, the sophistication often evaporates when it comes to the investment recommendation. This is apparent from the wide range of views on what is suitable for an investor with a particular risk profile. How, in practice, do advisers know that the portfolio they are recommending is suitable for a client who has, for example, been identified as a cautious investor? It is quite common to find that one adviser's recommendation for a balanced investor is another's for a cautious investor. Even more concerning, however, is that the client generally has no idea what to expect from the recommended portfolio or investment. In a world of "Treating Customers Fairly" (TCF), this is a serious shortcoming. If investor expectations are not managed properly, there is considerable potential for unwelcome future surprises for investors when investments deliver less than expected.
Stochastic modelling provides the scientific underpinning to the process of mapping a client's risk profile to a suitable investment recommendation. For the private investor stochastic modelling can perform three vital functions:
n to "scientifically" map asset allocations and portfolios to investor risk profiles;
n to produce "efficient frontier" portfolios which seek to maximise the return for the chosen risk profile; and
n to illustrate to investors the range of potential outcomes they can expect over different investment time horizons.
This last use is arguably the most important from the adviser's perspective since it enables advisers to meet a key TCF requirement i.e.
"Outcome 5 - Consumers are provided with products that perform as firms have led them to expect...."
Stochastic modelling provides a powerful way of illustrating the range of potential outcomes from an asset allocation or investment product. It provides a robust underpinning, linking risk profiles directly to investment recommendations in a way that should ensure that clients have reasonable expectations of potential outcomes.
Stochastic modelling also overcomes one of today's major advice issues – namely using the volatility of annual returns to risk rate portfolios. From a client's perspective, this definition of risk is virtually meaningless as it doesn't correspond to any typical investment goal or definition of risk e.g. capital loss over an agreed investment time horizon. Indeed a focus on short term volatility could possibly be detrimental to a long term investor saving for retirement. A more useful measure might be the potential size of a shortfall and likelihood of its occurrence – for example, if an investor's target is to have £200,000 in 15 years' time, it might be useful for the investor to know that there is a 70% chance of achieving this, but a 30% chance of not, with a likely shortfall of £30,000. The investor is then in a much better position to understand the risk being run.
Risk rated and target risk funds – the limitations
Whilst the FSA's guidance largely ducked the issue of how advisers should go about ensuring the suitability of their investment recommendation, the FSA did provide a few pointers:
"Even where the risk profile of the customer is correctly assessed, the product or portfolio (and
underlying asset-allocation) does not always match this profile. This can be due to a failure to select
investments that match the risk a customer is willing and able to take or a failure to take account of all aspects of a customer's investment objectives and financial situation".
The highlighted final words are of key importance. The challenge for risk rated funds is how to take account of a client's investment objectives and financial situation. How can a "one size fits all" solution work for clients with differing amounts of accumulated wealth, invested in ways that don't match their current assessed risk profile, and with different financial objectives and timescales. It is hard to see how risk rated funds can be used for anything other than for focused advice, for example, on how to invest this year's ISA investment.
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These challenges, however, are not insurmountable but the idea that advisers can simply risk profile clients, check their capacity for loss and then recommend a risk rated fund to match their risk profile is fundamentally flawed. The issue is about how to use risk rated funds with other investments to meet clients' investment objectives. The two case studies below illustrate how risk rated funds should be used.
Case study –taking account of the duration of the objective
Clients will obviously have different timescales for achieving their objectives. These need to be taken into account when selecting risk rated funds since the riskiness of a fund varies with duration. The example below shows for a client with a risk profile of 7 on a 10 profile scale, the mix of Old Mutual Spectrum Funds required to match this profile at different durations.
Fund mix required for risk profile 7
Case study –taking account of existing investments and the duration of the objective
In this example our client has £20,000 invested in the Fidelity Multi Asset Defensive Fund, which he does not want to sell, and £20,000 of cash. The table below shows how the money should be invested in Old Mutual's Spectrum Funds in order to match the client's desired risk profile of 5 and how this changes with investment duration. If he is determined not to sell his Fidelity fund, for an investment duration of 5 years, he will need to retain £8,800 in cash or find a lower risk fund than the Spectrum 3 Fund.
Fund mix required for risk profile 5
Conclusion
Risk rated and target risk funds can provide excellent client investment solutions. But they cannot be used without taking account of a client's desired investment term because the riskiness of any investment fund depends on how long the client is planning to hold it. The position can be complicated by existing investments that cannot justifiably be sold. Fortunately it's not rocket science to make recommendations that match clients' risk profiles, investment objectives and circumstances. Advisers have an important on-going role in maintaining client portfolios as circumstances change and investment time horizons shorten.