I think the regulator has been consistent in encouraging responsible investment and, in my view, has been particularly effective with its guidance on investment risk.
Criticism has come in volleys from various areas, especially from those who would remove the responsibility of effective due diligence from the adviser.
I read a recent opinion piece where a commentator was railing at his perception of asset allocation dominating (to the detriment) advice, ironic given his ties to a risk rating agency. He argued that ‘profilers calculate a risk level in the absence of an investment objective’.
No-one has suggested they should be separate, least of all the regulator who has dealt with this time and again over the years, re-referencing COBS 9 which states a firm’s responsibility to ensure that a recommendation ‘is suitable for its client’, including consideration of ‘financial situation’ and ‘investment objectives’. Spot on!
It is up to us as practitioners to live up to this principle and the only way this can work is if experience and expertise is married with good and on-going research. Clients quickly grasp the implication of failing to embrace sufficient risk in their portfolios.
Which is where the inspired concept of ‘Capacity for Loss’ comes in. If an investor truly understands the extent to which losses may occur in their investment lifetime, they will be prepared for downturns and volatility.
You need a model that can project a reliable view of the future.If the investor’s ‘Capacity for Loss’ has not been correctly addressed, they may not be prepared for losses along the way and are likely to crystallise those losses, or they are likely to find themselves invested in poorly constructed portfolios.
This approach worked in the last downturn and will work in the next. If you don’t believe this you shouldn’t be investing.
Investment is not speculation and modern portfolio recommendations must be optimised to capture the performance of the market over time for a level of risk specified. In order to achieve this, you need a model that can project a reliable view of the future.
This can only make sense if the model is able to ascribe probability to all possible outcomes for the full range of asset allocations. Synaptic achieves this with a mathematical simulation known as a stochastic modelling provided by industry experts Moody’s Analytics, proven in all market conditions over the years.
The graph below from Synaptic Modeller shows how our probability-based model can align an investment strategy (where we could be) with a portfolio recommendation.
The red line shows the impact of costs and inflation. (Scenario used is a pension investment for £100,000 with 10 year term).
5 golden rules of assessing risk
1) Do not rely on a single measure for risk
Consider everything, including historical measures including volatility, Sharpe and information ratios, years of data, historical drawdowns as well as the views of experts in qualitative research such as RSMR.
2) Use a stochastic model
This will provide a probability based perspective of likely outcomes. The fact you have quantified a worst-case scenario means that you can have a full and frank discussion around Capacity for Loss.
For example, the model will indicate the amount you could lose in a bad year (one in 20) – up to 5 per cent for Cautious strategy, up to 10 per cent for Moderately Cautious, up to 15 per cent for Balanced and so on. You can build your investment strategies on the research based asset allocations.
3) Set up your role as a coach and highlight importance of regular reviews
You need to discuss contingencies in advance, including if the markets go heavily against your client. For example, research shows that the success of a retirement investment strategy will very much be determined by the first few years of returns (‘managing sequence of return risk’).
4) Keep costs down
Good research will allow you to construct or at least assess and monitor portfolios relatively inexpensively. There is no point aligning with expensive investment solutions whose returns are decimated by avoidable costs.
5) Keep an independent research eye open
If they’re your clients, you will be on the hook for their profiling and any recommendations. Don’t fall into the trap of relying exclusively on the research or material of a third party, especially an outsourced investment firm, provider or platform.
You will not be equipped to advise effectively if you do not have access to research that helps understand what makes an effective investment strategy.
Time in the market and diversification may be the keys to investor success, but modern compliance requirements need full proof of suitability. Good research will make risk your friend, not a liability.
Adam Byford is managing director of Synaptic Software
Synaptic Risk ratings are available free of charge, visit www.synaptic.co.uk to register. These are also available within Synaptic Product & Fund research.
