Different ways to measure and assess risk

Therefore it is vital that an adviser grasps whether they are measuring risk ‘perception’, risk ‘required’, risk ‘capacity’ or risk ‘tolerance’.

Paul Resnik, co-founder of FinaMetrica, says advisers must evaluate a client’s risk capacity by analysing their financial circumstances and investigating the impact of different scenarios before any financial decisions are made.

Capacity

Risk capacity is therefore an absolute measure, he adds, while risk required is a financial characteristic and is the risk associated with the return required to achieve goals.

A client’s current and future financial position is considered, including their income, savings, expenses and liabilities, and then determining the rate of return they require to achieve their financial goals.

Mr Resnik says the advisers’ role therefore is to help clients identify their financial goals and ensure they are consented to, documented, quantified, prioritised and dated.

Required

Other factors are involved in assessing risk required, he adds, including state of health, longevity, inheritances, tax, children’s education, retirement, long-term healthcare and discretionary spending.

It is while talking about risk required that the adviser is truly educating the client about what they could potentially be taking on with an investment. This should give the client a reasonable perception and honest picture of the type of risk they are taking on.

Perception

Risk perception is the subjective judgment that people make about the characteristics and severity of a risk and is the threat a person sees in taking a particular course of action, Mr Resnik says.

It is all about how risky an action feels to them. Different people make different estimates of the dangerousness or gravity of risks, Mr Resnik notes. These risk perceptions can change and are not necessarily rational.

When investment markets are booming, for example, people tend to underestimate the level of financial risk, Mr Resnik observes. When markets are falling, he points out people tend to overestimate the risk.

Tolerance

Risk tolerance is about a client’s ability or willingness to accept declines in the prices of investments while waiting for them to increase in value. Mr Resnik says risk tolerance is an individual’s general willingness to take risk towards achieving their financial objectives.

The integrity of a risk tolerance questionnaire/tool ensures the accurate mapping of risk tolerance scores to investment portfolios, he adds. The most common way of assessing risk tolerance is via psychometric questionnaires, according to Mr Resnik, which is a branch of statistics.

It is concerned with the theory and technique of psychological measurement. In the case of risk tolerance, Mr Resnik says it is the objective scientific measurement of individual differences in risk tolerance.

He says it attempts to measure the psychological traits of individuals and to use that knowledge to make predictions about their risk tolerance and investment behaviour.

The majority of questionnaires ask a series of questions, the answers to those questions are then scored.

Mr Resnik says the score (usually on a scale of 0 to 100, with 50 as the average) represents the average risk tolerance and the score is then compared to the population. The working assumption is that the average person is of average risk, he says. Thus an above average score (greater than 50) means above average risk tolerance and vice-versa.

The score is then converted or mapped to an asset allocation/investment choice, he adds.

Mr Resnik says: “This is a critical component of advising on suitable investments for clients to reduce the likelihood of a client saying, ‘I didn’t know my portfolio might fail by that much’.”

Subjective view

The key thing for advisers to remember is risk tolerance and risk perception is a subjective view, says Vaughan Jenkins, financial services expert at PA Consulting Group.

Like risk perception, Mr Jenkins says it is about looking at the individual’s anticipated behaviour in the face of capital and/or income falls.

He says this assessment seeks to identify whether the client will buy and hold or panic sell in the face of adverse market conditions.

However in this uncertain economic climate, Mr Jenkins notes there are also many issues that will play into a client’s perceptions of the risks in the world around them and what type of investment they may consider too hot to handle.

For example, Mr Jenkins says geo-political risks, counter-party risks and currency risks are obviously complex in addition to the typical fund risks at a company or asset class level.

There are also risks in relation to the consumer themselves (for example, financial stability and behavioural traits), their investment time horizons and their goals.

Mr Jenkins says these risks may be assessed in a more qualitative way using psychometric tests to accompany traditional quantitative analysis.