How to manage risk in a client's portfolio

  • Describe some of the challenges relating to risk in a client's portfolio
  • Explain how to diversify a cleint's portfolio
  • Identify how risk impacts a client's portfolio

The FCA has found that of those with more than £10,000 in investable assets, nearly two-fifths do not have any investments at all and are holding all their assets entirely in cash. A further fifth were holding more than 75 per cent of their investible assets in cash.  

Why is risk management important when allocating assets? 

According to research conducted by Quilter and Boring Money back in 2018, DIY investors are missing out on up to 11.3 per cent of potential investment returns each year compared with a professionally managed portfolio because they suffer from seven investment ‘sins’. These are: 

  1. Holding too few shares, or being ‘undiversified’
  2. A bias towards the UK, ignoring the opportunities in overseas markets
  3. Lack of asset allocation diversification, using only shares when other assets could help
  4. Overtrading, fiddling around the margins of their portfolios
  5. Panic selling, ditching all their holdings at the first sign of trouble
  6. Not rebalancing, losing out on the proven ‘Rebalancing Bonus’ returns
  7. Lack of pound cost averaging

Each of these seven deadly sins results from a failure in risk management. 

While reducing risk often involves an action to be taken, potentially one of the costliest risks, that of panic selling during periods of market volatility, can be solved by simply doing nothing at all. This would have been painfully evident back in March and April last year as markets sold-off when the economic impact of the pandemic was becoming clear.

With red lights flashing all around, it takes great courage to resist the urge to sell-out and cut your losses. Sometimes doing nothing is the hardest thing to do at all, but history tells us that by doing nothing you will be rewarded. Anyone who sold out in March would have missed out on the subsequent recovery over the summer months and beyond. 

What level of risk is suitable? 

There is one general rule of thumb when it comes to determining an appropriate risk appetite. The longer the time-horizon someone is investing for, the greater the risk they should accept as they will have a longer time period to smooth out any short-term volatility. 

But risk is also incredibly subjective, and there is considerable variation in people’s perceptions of risk. Some people are naturally risk takers, and some are more risk averse. 

You would presume that less experienced investors tend to be more risk averse given they are new to the game and may want to dip their toes in first, but evidence suggests this is not the case. 

Recent research from the FCA found that nearly two thirds of new investors reported that a significant investment loss would have a fundamental impact on their current or future lifestyle, yet two-fifths did not even view ‘losing money’ as one of the risks to investing.   

This is where the value of an adviser really comes through. People’s perception of risk and how their portfolio is positioned are often way out of line. Whether that is someone nearing retirement with a portfolio of high-growth tech stocks; or someone in the early 40s leaving their savings entirely in cash and government bonds, advisers have an important role in teasing out clients' risk profiles and taking risk from a matter of subjectivity to one of objectivity.