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Chris Gilchrist: Get to grips with risk capacity

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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

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Readers' comments (7)

  • I have always felt risk is a subjective issue and the americans seem to have a very sensible approach by getting the cleint involved in the planning process and the issues that they as a client face.

    Ask yourself, in all honesty how many clients know what risk they want to take when you ask them the questions...Not many in realisty, most are led by us as they normall ask us what their answer should be, thats why they have asked for advice! However, most clients are not stupid and is it not our job as an adviser to asses and advise on risk the client should be able to accept given their overall position in order to achieve their goals, hihglighting the potential downfalls so an informed decision can be made???

    Often client's don't know what risk they want but they do want a hand in making an informed decision and are willing to listen to the justifications and caveats.

    I know this may be controversual, but advice is about added value and getting cleints involved, not just selling or picking a product once a load of questions have been answered, if the clients knew the answers to the questions they would be picking their own funds and wouldn't need advice.

    I have discouraged many from investing and placed sums across various deposits, whereas in other circumstances risk can be accepted provided it is justified and is understood.

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  • Only the wealthy can afford to have an attitude to risk.

    I wonder how many of the "others" will have received "compliant" advice which will ultimately result in them being poor in old age.

    The FSA need to understand that there is no such thing as a risk free investment. At best all we get to do is choose between one risk and another.

    A risk free investment is one where the risks are not apparent.

    Are you more concerend about potential capital loss now or by the possibility of your money running out before you do ?

    ATR only comes into play when capacity has been established. Even then the painting by numbers appoach currently fashionable is not the way to go.

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  • Good stuff. What Chris is talking about is also known as 'target risk'. So attitude to risk, capacity for loss and target risk. I could have a huge capacity for loss, a speculative attitude but no reason to take risk, i.e. no 'target risk'. So, why take any risk if you don't need to?

    Just because an 'adviser' won't make commission on bank deposits does not mean its not applicable for the client!

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  • Chris I think we agree risk profiling lies at the heart of investment advising. We argue that it is the process for determining a suitable investment strategy with regard to risk. It involves,
    • making separate assessments of risk required, risk capacity and risk tolerance, so that they can be understood and compared;
    • comparing the assessments to identify any mismatches; and
    • finding a resolution for any such mismatches.

    The outcome will be the optimal solution for the investor given the investor’s often-conflicting needs

    Ensuring that each investor has the investments that meet their needs requires sound processes, robust tools and advisory skills. This is a blend of art and science. The art lies in the adviser's ability to work collaboratively with clients to obtain an in-depth understanding of their needs, to use the tools effectively and to assist clients in resolving mismatches by identifying and explaining alternatives, and guiding the decision-making process. The science lies in the tools the advisor uses.

    Mental accounting is a very useful tool to help clients make sense of their goals. It can however cause practical difficulties if sub portfolios are developed to meet each goal. Reviews and rebalancing invariably lead to significant inefficiencies, such as selling down in one sub portfolio and buying in another at the same time.

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  • Attitude to risk is important but the real issue here is marketing -- if the marketing is not right complaints will be high, but get the marketing right and complaints will be so low that, statistically, they're difficult to measure.

    Marketing in this context, means attracting INVESTORS. If you only have investors approaching you for advice you don't need to invest a single SAVER. A saver will never be happy with any real investment because they will never understand them and are frightened by them.

    We've been following the US practice for years: We ask clients what there objectives are. We then design the solution. We solve their problem. They're happy.

    During the financial crisis we had four phone calls (out of a huge client bank). One chap said he'd stopped watching television. All of our client portfolios have recovered well and have met their primary objectives.

    Put this in the context of the banks and their desire to INVEST EVERYONE who receives a lump sum into their account and you can immediately see why they have collected so many complaints. They've invested SAVERS. Why? Because they've been driven by what the customer could do for the bank, rather than what the bank could do for customer.

    Whoops!

    Every successful business is focused on finding out what product/service the people NEED and delivering it in a profitable way. Give them what THEY need and they'll love you, even if it goes wrong; but give them what YOU want to give them and you'll never hear the end of it.

    So simple. So profound.

    Thought for Today: Advertising creates desire.

    Get the marketing right and everything becomes a whole lot easier.

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  • Paul, I agree about the three components. But my point is that capacity is to a significant extent more objective than either risk required (which will depend on unknowable future returns) and risk tolerance. You might argue about the science of risk tolerance but I contend that there is no scientific way of translating a tolerance score on its own into an asset allocation. That's why I think the capacity issue is, from a planning perspective, the primary one.

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  • Risk Capacity should certainly be the starting point with risk tolerance being of secondary importance.

    Sometimes a client has sufficient wealth to be able to do whatever they want with the actual investments being made being of little importance.

    More often a client has insufficient capital now to justify having a portfolio of so called safe investments. Keeping everything in cash will meaning running out of funds long before death. Investing in higher risk funds at least gives a possibility of success.

    Is it acceptable to virtually guarantee poverty in old age simply because 20 questions indicate a low tolerance for risk ?

    I wonder how this would work in a medical senario ? Would it make sense for me to tell my doctor that my attitude to health meant that I wanted to be told that I had a headache rather than a brain tumor.

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