If someone is ‘invested in line with their Risk Tolerance’ as it’s typically understood when Risk Tolerance is loosely used as a proxy for overall suitability, there’s a high chance they’re taking an unsuitably low level of investment risk. The wealthier they are, the more unsuitably low this level is likely to be.
An investor’s suitable level of investment risk is a function of their willingness and ability (both financial and emotional) to take that risk, adjusted, where necessary, to account for their knowledge and experience, and a handful of relevant preferences.
In practice, willingness ought to be measured by Risk Tolerance, financial ability by Risk Capacity, and emotional ability by Behavioural Capacity. For most investors, their Risk Capacity – a dynamic reflection of their current and future financial circumstances which shapes their reliance on their current investible assets to fund their future spending needs – is by far the most important element of this equation.
However, this is commonly not what happens.
Shackled to a past that saw Risk Tolerance and Suitable Risk Level as interchangeable, hindered by a misunderstanding of the role of Risk Capacity, and assailed by a fear of ‘deviating too far’ from a sacrosanct Risk Tolerance score even where there is a clear, systematic, and evidence-based justification for doing so, advisers routinely (and unwittingly) under-risk their clients, especially the wealthiest ones.
Deciding the Suitable Risk Level by anchoring on a Risk Tolerance score, and then subjectively nudging it up a bit if a client has chunky cash reserves or high future earnings potential, could easily be costing the wealthiest clients millions in foregone returns. This does not just disadvantage clients, but also sacrifices potential fees for advisers and distorts policymaking for the country at large through a range of knock-on effects.
This is not a marginal effect.
How the wealthiest miss out most
To demonstrate the scale of this issue, we compared Risk Tolerance and Suitable Risk Levels for over 55,000 investors that have been assessed using Oxford Risk’s suite of suitability tools.
The key findings are:
- Using a scale of 1-7 for each measure, the average Suitable Risk Level is 0.73 points higher than the corresponding Risk Tolerance.
- Only a little over one-third (37%) of investors end up with the same Suitable Risk Level as they would do if it were based only on their Risk Tolerance.
- There’s a significant wealth effect. 55% of those with total investible assets over £2m have a Suitable Risk Level that’s higher than their corresponding Risk Tolerance (it’s lower in 8% of cases). For those with total investible assets under £2m, the Suitable Risk Level is higher in 36% of cases, and lower in 27%.
Consider a client in approximately the middle of this group: with Risk Tolerance of 4, and a Suitable Risk Level of 5. If they had been invested in line with their Risk Tolerance only, and we crudely translate that into expected returns foregone (relative to being suitably risked) over a 10-year period, it would mean a shortfall in expected long-term growth rate of 0.7% p.a., meaning over those 10 years, the client would be missing out on approximately £10,000 of growth for every £100,000 of initial investment value.
Helping HNWIs grow wealth more effectively
Most wealthy investors have a relatively high Risk Capacity. This comes from two main sources:
- Net non-investible assets – Typically through owning a home with a sufficiently low mortgage (LTV < 50%), as well as other assets (e.g. second homes, cars, collectibles, boats, etc). While using a home, say, to fund expenditure may be done only as a ‘last resort’, a last resort isn’t no resort, and thus people who own these assets have more scope to take risk with their investible assets than those that don’t. For more on the role of property in Risk Capacity, see our article How Your Home Affects Your Investment Risk.
- Net future assets – Pre-retirement investors with a surplus of income over expenditure are less reliant on their investments to fund future expenditure, meaning they can comfortably (from a financial point of view at least) take more risk with those investments. Future assets also reflect stores of human capital: an investor may be investing only a small proportion of their wealth, because a lot of their wealth hasn’t been earned yet (but will be). The low Risk Tolerance individual with 35 years of accumulating a high salary ahead of them would be dramatically under-risked if they invested their current investments cautiously. This does not diminish the relevance or stability of Risk Tolerance itself, but reflects the fact that a low willingness to take risk does not automatically imply a low suitable level of risk when Risk Capacity is high and long-term financial resilience is strong.
A high Risk Capacity affords an investor a clear opportunity, and justifying rationale, to take more investment risk (rubber-stamped, of course, via discussion with their adviser). This translates into a real expectation to build more wealth and financial resilience than they would have done (and often think they are able to) through relying on Risk Tolerance (or a subjectively, and too-cautiously adjusted Risk Tolerance) alone.
In practice, this need not be complex. Risk Tolerance should act as a stable anchor, reflecting an investor’s enduring willingness to take risk at the level of their total wealth. Risk Capacity then determines the level of risk that the investor’s investible assets need to take in order for the investor’s overall financial position to be aligned with that Risk Tolerance. Behavioural Capacity, in turn, constrains how that suitable risk level is implemented and reviewed over time, ensuring that portfolios remain emotionally sustainable through market stress.
Suitability as a spur for growth
There’s no reasonable justification for investors to put up with under-risked portfolios because of misunderstandings of the mechanisms of suitability assessment, or the lingering fears of an industry still haunted by the ghosts of a less-sophisticated past.
Risk Capacity isn’t only a measure of an investor’s financial ability to take risk. Well understood, and suitably applied, it unlocks an ability to build wealth too. Used properly, it also helps advisers align growth-oriented recommendations with good client outcomes and the intent of Consumer Duty, rather than constraining portfolios unnecessarily in the name of caution.
