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Alistair Cunningham: Drilling down into capacity for loss

Assessing clients’ capacity for loss requires a different conversation to risk tolerance but advisers’ views on digging deeper will vary.

Risk profiling questionnaires have significant issues and we use them as part of a far broader discussion of the investment risk someone is willing and able to take.

Capacity for loss is a related but different conversation. I do not profess to be an expert, but I strongly believe that it is our role as an adviser to express our views on how a client might be able to withstand market shocks, or otherwise, and how they can prepare themselves accordingly. 

This view is certainly not universally held.

There are those who believe capacity for loss is a fictional construct. As markets will only fall temporarily, they believe that to invest in anything other than 100 per cent equities is a disservice to clients and that they need to be “behaviour managed” through the irrationality of falling markets.

The problem with this opinion, in my view, is that it does not take into account the extremes of market reduction and that this could also impact at a time when a client is drawing from their capital. 

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A £4,000 output from a £100,000 fund may be prudent – but if the fund is £50,000 due to a 50 per cent downturn, then the markets need to more than double (117 per cent growth) in order to return the fund back to £100,000.

There is limited value in client input too, particularly in some of the potential responses to “what would you do if the market fell by xx per cent?”. This is usually a risk tolerance question and may not tell us anything about the financial implications of capacity for loss. If the answer is emotional (“I’d not be able to sleep”, “I’d cash in”, “I’d buy more” etc) then this might adjust the risk score for obvious reasons but it tells us nothing about capacity for loss unless the answer is financial (“take fewer holidays”, “borrow some off a relative”, “cash in my premium bonds”, “starve” etc). 

But these are general fact-finding questions and can come from good cashflow planning.

Modelling a financial crisis on a cashflow plan can be counter-intuitive. I suspect the reason that some individuals are compelled by the “hold more equities” approach is they make a long-term financial plan look rosier – it’s not surprising if you are using a deterministic approach where the effect of equities, over the longer term, is to increase your anticipated returns.

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Stochastic modelling may go further to show the uncertainty of these returns, but both systems rely on the fallacy that investment returns are normally distributed. 

In reality, the “long tail” outlier events may be more common. Attempts to tweak a deterministic model to be more pessimistic by simply using bottom quartile returns, for example, do not fairly represent what might happen. So, if we think a 25 per cent downturn is very unlikely, what are the actions we would take if this happened and what can we do to improve resilience? 

Clearly the individual willing to take fewer holidays might need to do little but other individuals may need cash buffers, partial annuitisation, insurance or similar.

The problem now is that markets may well be irrational but in an overly positive direction and investors have a greater feeling of security than the reality. 

When there is an inevitable correction, if the only feasible plan is to sell in order to survive, the next downturn would be a lot worse than the last.

Alistair Cunningham is director of Wingate Financial Planning

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