You wouldn’t use a hammer to cut a piece of wood or use a screwdriver to saw a log. It is the same with risk management – use the wrong risk measure on a client’s portfolio and you can botch the job, generating data that gives them a misleading view and pushing you toward making unsuitable recommendations.
There are numerous factors that will impact an investor’s investment risk profile. For example, increasing longevity, political and regulatory change, personal lifestyle issues such as becoming a parent, getting married or divorced, inheriting a large sum of money or becoming too ill to be able to work. All these factors can conspire to impact a client’s chances of meeting their financial planning objectives.
Aside from these complex external factors, there are four typical risk measures available for advisers when considering investment risk: value at risk, capital at loss risk, underperformance risk and journey risk. All can be used to paint a different picture of the same scenario, and while some are useful in most client situations, others will be completely misleading in others. The right risk measure can make a powerful case for the best course of action for your client; use the wrong one and you can make an equally compelling case for the worst.
Unfortunately, many advisers only tend to talk to their clients about journey risk. The extent and likelihood of a fund value fluctuating either side of a particular trajectory through time. If you are investing for a retirement decades into the future the impact of journey risk in the short term is very small, and in fact can be beneficial for regular savings due to “pound cost averaging” where temporary dips in prices mean you can buy more units overall.
If there is a big crash when you are 20 years away from retirement, that is not a problem by itself because while the value of your portfolio may have fallen, it also means your regular savings can buy units more cheaply When these units then revert back to normal price a larger return is made on those particular units.
Ask a long-term pension saver whether they are comfortable with a 15 per cent fall in the value of their pot and many will say no, even though an expert might see such a level of risk as completely acceptable. By focusing on journey risk, advisers risk pushing investors toward not taking enough risk and potentially missing out on decades of performance from high-yielding asset classes.
Value at risk is a measure that shows the investor the worst-case scenario they might expect, making a statistical analysis of market trends and volatilities to estimate the likelihood that the losses of a particular portfolio will hit a certain amount. Value at risk is usually shown as a specific percentage chance that a portfolio will lose a certain monetary amount, and is a useful way of communicating the perils of different approaches to portfolio construction where assets are being drawn.
A portfolio might be described as carrying a 50 per cent risk of suffering a 20 per cent drop in the first year. This more sophisticated measure is harder to assess but is really useful for a pension drawdown investor grappling with how much volatility in both fund size and withdrawals they are prepared to live with.
Capital at loss risk is a simpler measure designed to speak to our behavioural aversion to losing money. It shows the likelihood an investor will end up with less than they started with. That is great for people who are hard-wired against losing a single penny of their cash, but does nothing to show how inflation erodes cash over time, or how much potential upside the investor is excluding themselves from by taking a cautious approach.
Measuring the probability of a portfolio delivering less than the return on minimum risk investments, such as gilts or cash is a useful way of explaining the pros and cons of investing in higher risk assets. This way of looking at risk is particularly useful when showing investors how asset classes with a higher risk/return profile tend to become less risky the longer the investment is held.
Risk measures are like any other tools – you have to use the right one for the job if you want to achieve the best possible outcome.
Andrew Storey is technical sales director at eValue Investment Solutions
