Risk profiling

Mistermeaner

Re the principle of assessing one’s attitude to risk when determining possible investment strategies:

I get that we all have a different view and tolerance to risk (in all things) and that this also applies to investments and potentially one’s ability to sleep at night as our savings bounce around on the rollercoaster of stock market rises and falls…..

However why is it relevant to assess an individuals’ attitude to risk when determining the appropriate investments? Reason I ask is that isn’t any individuals attitude to risk irrelevant vs their objectives and goals in determining the optimum investment approach ?

e.g. someone in their 20’s savings into a SIPP that they won’t access for 30-40years should surely be in ‘high risk’ investments regardless of their individual tolerance to risk or are they not in fact exposing themselves to greater risk by missing out on the gains to be realised over such a long period of time?

In my personal experience before going DIY I went to an appointment at nationwide to see their investment advisor – she did a questionnaire with me to profile my ‘risk attitude’ which spat out a score of 5 out of 7 and lead to a recommendation of funds to fit that… however isn’t this just meaningless compared to what I was saving for? I don’t recall being asked about whether I wanted this money for a house deposit in 5 years or was intended to cover my childs university in 15 years or was to pay off my mortgage in 25 years or was to be for my retirement in 35 years or indeed was intended to never be touched but passed onto my grandchildren when I die in 50 years time

HappyHarry

The length of time a client is investing for is certainly part of the criteria for establishing attitude to risk. If this isn't taken into account when risk profiling, then I would be very wary.


However, it is not suffice to say that a 20 year-old saving for retirement should have in a high risk profile, or a 70 year-old with a 10 year investment strategy should have a low risk profile.


Taking our 20 year-old. If they invest in a high risk area, and lose 50% of the value of their holdings when the markets crash, there is a good chance that this will put them off investing for a long time, which would clearly be to their detriment.


Far better would be to assess their risk profile initially, maybe adjust it upwards a little due to the long-term nature of their investments, and then, three or four years' later, re-assess their risk profile, and adjust their invetsment strategy as necessary. Keep doing this until retirement, and that 20 year-old (now 60) will have regularly reviewed their appetite for risk, have had an appropriate startegy throughout, and won't ever have had serious disillusionment following a market crash.


Investment strategies are not just about maximising growth. This is an error that many DIY investors make. We have all seen on these boards, posters, who try to chase the best peforming investment for the lowest price, without considering how they will feel come a market crash. Come the inevitable market crash, there is often either silence as the poster gives up, or bitter recrimination about how much they have lost compared to other investments.


I have many clients that would be terrified with the thought that their invetsments could fall 50%, regardless of the eventual growth they could acheive. Some of these are in their 20s and 30s.


Strangely enough, I think it's something that NEST does reasonable well in their pensions. As a default, it starts people in a low risk invetsment strategy, after a few years it increases the risk of their investments, and approaching retirement, it again lowers the risk of the invetsments. It is far from fool proof, and more than a little clunky, but for people with little idea of investning and not taking advice, it's not a bad strategy.

dunstonh

However why is it relevant to assess an individuals’ attitude to risk when determining the appropriate investments? Reason I ask is that isn’t any individuals attitude to risk irrelevant vs their objectives and goals in determining the optimum investment approach ?

No point investing in assets with a 25% loss potential if the person does not have the behaviour to handle a 25% loss. They will just make bad decisions at the time and compound/crystallise their losses.

You must have heard of people who say they will never invest on the stockmarket as they lost money. That is someone who invested outside of their risk profile and level of knowledge and understanding.

In my personal experience before going DIY I went to an appointment at nationwide to see their investment advisor – she did a questionnaire with me to profile my ‘risk attitude’ which spat out a score of 5 out of 7 and lead to a recommendation of funds to fit that…

That is also wrong (as you describe it as reality may be slightly different). The risk questionnaire score is just the starting point. It sets a basis point but further non-scoring information should be used to differ that if necessary. Indeed, this is a major weakness of robo-adviser risk scoring methods too.

It is not uncommon for people to answer as they think they should be answering. However, when the actual risk event occurs, they just cant handle it.

however isn’t this just meaningless compared to what I was saving for?

Its not meaningless if the first thing you do in a loss period is draw all the money out.

I don’t recall being asked about whether I wanted this money for a house deposit in 5 years or was intended to cover my childs university in 15 years or was to pay off my mortgage in 25 years or was to be for my retirement in 35 years or indeed was intended to never be touched but passed onto my grandchildren when I die in 50 years time

With a full advice service, the objective is important. However, with guided services (like robo-advice - which is what Nationwide offer) it is not an issue. Its not part of their remit.

It is very common to see DIY investors invest above their risk profile.

Mistermeaner

Thanks guys; I guess my issue with the risk approach is the part about someone freaking out and withdrawing all investments at a low - this would clearly not be in self interest

But likewise going for 'safe' investments is compromising returns over a long enough period - again not in self interest

Isn't the issue one about understanding and education rather than risk?

Once someone understands that while 'high risk' investments might bounce around in value over the short term they will (at least history tells us) more than recover over the long term and produce overall better results - the issue to address is therefore to educate people to ride out the lows rather than protecting them from themselves with sub-optimal investments?

dunstonh

Isn't the issue one about understanding and education rather than risk?

MIFID II has not helped in this respect. We have seen a few less experienced investors request their investments closed as they lost money on their latest statements at a level they have not seen before.

The thing is that they have seen it before but the statements are now required to be quarterly. Whereas before it was 6 monthly or yearly. This extra time between statements meant that loss periods were less noticeable. For example, pre MIFID II 6 monthly would have seen a statement in October (before the drop) and April (after the drop and bulk of the recovery). However, the statement in December was just days after the lowest point.

Some people just cant handle it.

You can explain things to people but there is no guarantee they will accept what you say. They can tell you that they will accept x% in losses. You can put it in monetary terms do they really make sure. And they say yes. But when the event happens, some will just cave despite what they said.

We have seen it on this board where people invested after long procrastinating threads about whether it should be VLS or L&G or whatever and what equity level to choose. They say they will go with a certain level and then when the drop comes, they start to panic.

Some people dont want to understand. Some people say they understand but in reality, they dont. This is why the FCA tell advisers not to rely solely on risk scoring. Yet strangely they have no problem with it on directed services.

HappyHarry

Mistermeaner wrote: »

Thanks guys; I guess my issue with the risk approach is the part about someone freaking out and withdrawing all investments at a low - this would clearly not be in self interest

But likewise going for 'safe' investments is compromising returns over a long enough period - again not in self interest

Isn't the issue one about understanding and education rather than risk?

Once someone understands that while 'high risk' investments might bounce around in value over the short term they will (at least history tells us) more than recover over the long term and produce overall better results - the issue to address is therefore to educate people to ride out the lows rather than protecting them from themselves with sub-optimal investments?

Many people won't be comfortable with high risk strategies, regardless of how well long-term growth is explained to them. Take a look at the Ombudsman database of complaints, and you will find a huge number of complaints where clients have lost money because they were invested in too high a risk level investment strategy. Many of these complaints are, quite rightly, upheld.

For example, I have a very clear understanding of risk and reward, and I am not invested in the highest category of risk. My portfolio is not 100% equities, even though I know over the long-term they will likley do better than mixed asset portfolios. Many of my clients have a higher risk profile than me, which is right for them. Many more of my clients have a lower risk profile, which is also right for them.

It is not a bad thing to invest below the maximum risk level. It is bad thing to invest above, or below, a risk level that you are comfortable with.

From your comments, I would guess that your risk profile is higher than mine, and I understand why you might think that my approach is sub-optimal.

However, I understand that the journey is as important, if not more important than the end result. Investing uncomfortably for 40 years is not in any one's best interest, regardless of the final outcome.

You have to remember that risk-profiling deals with real people and their emotions, and not spreadsheets.

JohnRo

Mistermeaner wrote: »

...In my personal experience before going DIY I went to an appointment at nationwide ..

I'd suggest that's a Nationwide problem rather than a risk profiling problem.

Mistermeaner wrote: »

...However why is it relevant to assess an individuals’ attitude to risk when determining the appropriate investments? Reason I ask is that isn’t any individuals attitude to risk irrelevant vs their objectives and goals in determining the optimum investment approach ?

That the historic volatility of a particular investment is seen as a proxy for it's risk of potential future loss (albeit temporary) and that people's attitude to that potential future loss on their investment valuation will be very different, as will thier all important behaviour.

Personally I think it's impossible to properly understand your attitude to investment volatility/risk if you have never been exposed to it and more importantly experienced it.

A good adviser with a new client who has never invested has a thankless task but can perhaps, in conversation, read between the lines and steer things in an appropriate direction. The DIY investor on the other hand will only understand how they truly feel about 'losses' once the journey is under way and they've run into those 'losses' for real.

At that point it's not just the magnitude of a valuation drop that can shake confidence and prior conviction, there's also the duration of that fall to consider which can whittle away at resolve.

Many / most people could probably stomach a brief ten percent fall and subsequent recovery but if that same fall stuttered and spluttered on, failing to recover much ground for many months then some will begin to lose confidence and the inevitable doubts about the choices made will begin to creep in, especially if other options appear to have been doing better.

It's then that the doubt, fear and in some cases panic sets in and dictates subsequent behaviour which in turn leads to the likelihood of real damage being done.

For new DIY investors it's perhaps better, as already suggested to err on the cautious side and see how that 'feels' for a time before deciding to up the stakes.

Malthusian

JohnRo wrote: »

Many / most people could probably stomach a brief ten percent fall and subsequent recovery but if that same fall stuttered and spluttered on, failing to recover much ground for many months then some will begin to lose confidence and the inevitable doubts about the choices made will begin to creep in, especially if other options appear to have been doing better.

And don't forget that at this point, every newspaper and TV programme will be full of experts telling them that the recession will last a decade, global trade has ground to a halt, this is unlike any stockmarket fall in history and they should sell everything before they lose any more.

This point is often forgotten because we only have these conversations during bull markets when the newspaper money pages are broadly positive about investing in shares.

100% of novice investors who have been taught the concept of buy-and-hold think they are part of the 10% that would ignore the majority and the mass media and hold their nerve throughout a crash. 90% of them are wrong, as proven by any stockmarket graph that covers 2007-2009 or any other proper crash.