Attitude to risk vs capacity for loss: Risky business
No investor can be guaranteed a high return, but it is clear that some clients are more able to tolerate risk than others. In an ideal world, a customer’s attitude to risk and their capacity for loss would match up and work together in perfect harmony. Their perception of their ability to absorb loss would correspond to the amount of risk they were willing to take, but that is rarely the case.
Since March 2011, when the FSA began to raise concerns surrounding advisers assessing their clients’ ability to absorb risk, this has been a topic for discussion among those in the industry.
The previous regulator stipulated that investment risk assessment must be a key part of dispensing advice and guidance, and a part of the process that needs to be taken seriously by all parties involved. The FCA has made clear the subject will continue to come under its regulatory scrutiny. In its most recent thematic review in October this year, technical specialist Rory Percival said that “good practice was hard to find” in the research.
Steps from the investment world
One approach to sharing the responsibility for client risk is the introduction of risk-rated and risk-targeted funds. These have become more numerous over the past few years, which could correspond to greater demand for clarity on risk.
Simply put, the difference between risk-rated and risk-targeted funds is that the former is a label while the latter is a strategy. Both revolve largely around volatility, with risk-rated funds relying particularly heavily on this.
There is a danger, though, that by cornering off a section of the market as ‘risk-rated’, inexperienced investors perceive these particular funds as more appropriate for the risk-averse than others.
“I think that risk-rated funds are an accident waiting to happen, and particularly those that are for lower-risk investors,” says Andrew Merricks, head of investment at Hove-based consultants Skerrit. “Everyone knows that something like gilts are overvalued. Everyone knows gilts are going to lose people money at some time, but risk-rated funds will still be overweight gilts. Just because they’ve got a low risk number on them that’ll be misleading and cause some sort of issue at some point.”
For advisers, one of the principal problems with risk-rated funds is the lack of standardisation across the industry. It would not be too much of a logical leap to claim that ratings have very little intrinsic meaning when one considers that each company sets its own risk scale. This is where an adviser who can compare across various risk scales would come in useful, but the impenetrability makes it difficult for individuals to make informed choices about their investment and raises questions around transparency and accessibility.
