Chris Gilchrist: Get to grips with risk capacity

Since the FSA’s guidance last year on the issue of risk capacity, people have been redesigning their risk-profiling processes. The FSA rightly says “suitability” must include assessment of someone’s capacity to withstand losses. In a financial planning context, I would widen that to mean capacity to withstand shortfalls in relation to needs (for example, in retirement income).

It has always seemed to me that the assessment of what risk the client can afford to take based on their circumstances and resources (and many other factors too) should take precedence over their tolerance for risk, however it is measured.

It does not matter how accurate your psychometric questionnaire is. All it tells you is what the client feels. It does not tell you anything about their ability to cope with loss or shortfall. One of the planner’s skills is, or should be, that they can envisage the consequences of a loss or shortfall better than their clients can and they should use that understanding to make the issue real to clients so that they make better decisions.

It is hard to put the tolerance questions together with questions about capacity because a good psychometric questionnaire must focus on attitudes. So, some providers of those questionnaires have backed off the capacity issue and said clearly that it is the advisers’ job to assess capacity and advisers should not allocate the client a risk profile without considering this.

Other providers of risk profiles have built in what they think of as adequate capacity questions but these will not satisfy a professional planner.

The reason the quant guys are struggling is that capacity is circumstantial, so any number of idiosyncratic circumstances can combine to constrain capacity, which means it is hard to build a good model. Nevertheless prescriptive models are being built that will be used by restricted advice chains. They will be crude and designed primarily to limit the adviser’s liability and to enable investment recommendations to be driven straight from the questionnaire output – in other words, old-style risk profiling reinvented.

How should a professional planner approach this? Interestingly, planners in the US tend to approach this issue from the other end. They work out what risk the client needs to accept in order to achieve their goals and then negotiates with the client as to whether they can really live with the consequent volatility. That seems a good way to proceed if you adopt goal-based planning – everything follows from the goals.

Of course, you are then likely to end up with several different portfolios because the client will accept different degrees of risk in relation to different goals. This type of mental accounting is often decried by behavioural finance geeks but it is a fundamental feature of the way we deal with reality at large, so it is by no means exclusive to finance, nor need it be a handicap in our dealings with the world.

I feel planners do better to use mental accounting as a positive feature in helping clients comprehend and engage with their financial planning. Incorporating risk capacity questions in your fact-find seems a good idea but it is only a partial solution. Advisers probably need to use prompt sheets and think hard about lines of questioning. There really is no easy answer to this one.

Chris Gilchrist is the joint author of The Process of Financial Planning and editor of The IRS Report