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Danby Bloch: What risk capacity means in practice

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Every adviser needs to assess clients’ capacity to take on investment risk. The FCA defines this as a “customer’s ability to absorb falls in the value of their investments”. In broad terms this means advisers have to take into account losses that would have a “materially detrimental effect on [a client’s] standard of living”.

That seems simple enough, but it can get trickier once you think about what it means in practice.

On one level, the idea is easy to grasp. The key factors for determining risk capacity are essentially objective and include:

  • The client’s level of income and wealth.
  • Their expenditure needs.
  • Their investment timescale.
  • Their need for liquidity.

Risk capacity is quite different from risk tolerance, which is about subjective and psychological issues – how the client feels about the possibility of losses or fluctuations when investing. There is generally a link between risk capacity and tolerance: the richer you are, the more relaxed you are about risk.

But in real-life capacity for risk has some substantial subjective aspects to it, even though it rests on objective factual foundations.

Case study one: Watching capital value

Meg lives on the income from her state pension and her investments. The capital value of her investments is of secondary importance to her. What concerns her is the flow of interest and dividends from her portfolio. The gross dividend yield (dividend plus tax credit) from the FTSE All-Share index has been remarkably steady over the past 15 years, according to Barclays Capital. After the 2008 crash, dividends fell by a tenth of their 2008 value but they recovered two years later.

Meg also recovered from her understandable queasiness about the drop in capital values in 2008 and 2009. They did not affect her standard of living. If she had held mostly cash deposits, her income would have fluctuated worryingly and finally fallen a lot, although her capital would have been safer and would have just gradually eroded.

If Meg had been drawing on her investment capital to supplement the natural income from her portfolio, her capacity for loss would have been significantly lower because of the effect of reverse pound cost averaging – or pound cost ravaging. 

But not all falls in capital value would be so relatively benign for a person like Meg. Some equity markets have bounced back but some have not. And some property and other investments might have caused her a sudden and permanent loss of both capital and income.

Case study two: Building a pension portfolio

Pete is in his early 40s and is building up funds for his retirement. He is vague about when this will happen but using reasonable scenarios he knows he needs to save about £20,000 a year and have a return of about 4 per cent a year. Could he afford to take a 40 per cent drop in the value of his investments? 

The sudden drop in Pete’s pension fund probably would not have an immediate impact on his standard of living. But it is likely to have consequences. One would depend on how long it might take the value of the portfolio to recover – assuming it does recover. Sometimes investments recover quickly, sometimes it takes several years (1972 until 1983 in inflation-adjusted terms) and sometimes it does not happen at all (Japan post-1989).

After a very deep fall, unless the recovery turns out to be very fast, Pete’s portfolio would probably experience a long-term loss of growth. So Pete might be well advised to increase his savings pattern to make up for the lower long-term rate of return and keep the position under review. Otherwise he could retire later or on a lower retirement income. 

Would the consequent loss of net spendable income either now – because of his higher level of regular pension savings or possible reduced standard of living in retirement – constitute that materially detrimental effect on Pete’s standard of living?

That depends partly on how many years Pete has until his target and how long he could boost his rate of savings. Increasing annual savings by a small amount of, say, £5,000 a year for 20 or 30 years is a lot less detrimental to one’s living standards than a shorter timeframe.

So the question should be – how much loss can you tolerate? Part of assessing risk capacity is subjective. 

As King Lear said: “Our basest beggars are in the poorest thing superfluous. Allow not nature more than nature needs.”

Danby Bloch is editorial director of Taxbriefs Financial Publishing

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Comments

There are 10 comments at the moment, we would love to hear your opinion too.

  1. “There is generally a link between risk capacity and tolerance: the richer you are, the more relaxed you are about risk.”

    Seems ‘obvious’ but I would challenge this. Being rich doesn’t mean you can afford to lose money, that depends on outgoings, objectives, etc. as made clear in the article.

    Risk tolerance is a trait that is largely immoveable if academic study is to be believed.

    If there is empirical evidence they are linked I’d like to see it but I doubt it’s true.

    Good article otherwise.

  2. Yes, an erudite article with relevant examples.

    Danby’s point re the link between capacity for loss and wealth is, however if not a little naive, rather over-generalised. The link is tenuous and relates to “remainder wealth”, ie however great the loss in percentage terms, the nominal remainder may still be relatively substantial. However, as Grey Area implies, this ignores utility. My spending needs may be so great that what appears a large nominal remainder amount, may be devastating given my penchant for quaffing Cristal.

    Consequently assessing capacity for loss is not something scored on a questionnaire. It has to be uncovered through discussion, and stress tested with some scenario analysis – “Your apparent tolerance for a loss of 20% in a year means you lose £1m. At 2% growth a year that will take 11 years and 3 months to recover (since your investment will need to grow by 25%). You’re 60. How do you feel about that?

    How many risk profiling tools do you see conflating attitude and capacity? Too many for my liking…

  3. Chris Gilchrist 15th August 2014 at 1:22 pm

    I don’t entirely agree with Graham: you can gather useful data on capacity via a questionnaire, and you can score for some aspects of capacity, eg timescale, expenditure needs. But no questionnaire can gather all the data you need to assess risk capacity because it is heavily circumstantial, which is why box-ticky questionnaires and profilers rely on ATR – which is what quite rightly concerns the FCA .

  4. One of the great dangers for naive advisers and their clients is the confusion between risk capacity and risk attitude; they are two entirely different things. I’d go as far to say that risk attirude is virtually the least inportant factor to be considered when determining the suitability of an investment portfolio or product for an investor.

  5. David is correct. Generally, the ATR has become a short-cut to a model portfolio or other CIP.

    A investor probably has three “states” regarding risk:

    Attitude – The willingness to take risk. This is the “bravery’ state, and one which has least to do with utility – it’s the same as gambling with dummy chips. Easy to talk the talk…
    Need – Given the investor’s objectives, attitude is less relevant. Someone who only needs 3% pa to achieve their goals probably doesn’t need a risk level 10 portfolio, even if that’s what the ATR suggests
    Capacity – The ability/means to accept losses. How will the investor’s current and anticipated lifestyle be impacted by a certain degree of loss? Does the investor understand the recovery period following a loss, at various potential growth rates?

    Then there’s the adviser’s inherent bias regarding investment per se. Does your attitude to risk get in the way of an objective assessment? Probably. It’s therefore worth considering whether you are talking “up” risk because of your market views, or talking risk down because of the fear of reprisals if it all goes wrong.

    And finally – Principle 6, the client best interest rule and the impact of price/value. Sometimes you may need to factor in a value to avoid an economically irrational decision, eg where longer term impact of price reduces the likelihood of outcomes being achieved.

    All this points to deep discussion, as you’d expect for the fee, rather than merely a naive questionnaire… questionnaire

  6. I agree with Graham Bentley | 18 August 2014 1:19 pm – The questionnaire is just the structure which enables the conversation. It also allows us to highlight where the clients statements are at odds with a conflicting risk view or where existing investments are at odds with a risk assessment.

  7. One aspect that is often overlooked with ATR questionnaires and particularly the psychometric ones concerns the nature of the questions and possible responses. The question and its phrasing is often likely to alienate anyone who has acquired their wealth through professional career or entrepreneurial endeavour. For example:

    Taking financial risks is important to me. Strongly agree/Agree/Neither/Disagree/Strongly disagree.

    Does such a question offer any other impression other than it’s all part of a process only designed to cover the IFA’s backside? I’m sure that others will have their own favourite examples.

  8. One aspect that is often overlooked with ATR questionnaires and particularly the psychometric ones concerns the nature of the questions and possible responses. The question and its phrasing is often likely to alienate anyone who has acquired their wealth through professional career or entrepreneurial endeavour. For example:

    Taking financial risks is important to me. Strongly agree/Agree/Neither/Disagree/Strongly disagree.

    Does such a question offer any other impression other than it’s all part of a process only designed to cover the IFA’s backside? I’m sure that others will have their own favourite examples.

  9. For what it’s worth, that example question exhibits at least two instances of poor practice vis assessing suitability and Regulator’s concerns surrounding ATRs. Can anyone spot what they are?

  10. I have no idea what is the meaning of the statement “Taking risks is important to me”. What kinds of risks, what degree of risk, what likelihood of risk? And what does “important to me” signify? Does it suggest something that is so attractive that I would want to do it, or perhaps something so repellent that I would want to avoid it? And even if I adored taking risks, so what?

    It is just one of those egregiously ambiguous questions that amateur psychologists like to insert in risk tolerance questionnaires.

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