Pairing Risk Capacity with Knowledge and Experience

When offering advice to your clients, a Risk Capacity assessment may be a part of the risk profiling instruments employed, but how much do you understand such assessments, their value, limitations, and role in an investor’s risk profile?

Gillan Williams
Author Gillan Williams
Date 4th October 2016

Risk Capacity

Risk Capacity refers to the client’s ability to bear loss, and specifically whether losing all or part of an investment would substantially impact their lifestyle. The term will, in its entirety, encompass the circumstances of the investor when applied to a given investment. Risk Capacity will therefore change significantly from goal to goal, as each investment will have a unique set of circumstances, importance and impact associated with it.

Assessing all the possible Risk Capacity elements, or the bias the investor may have towards an investment goal, is a challenge that can never be fully supported through a score based algorithmic assessment. There are simply too many possible circumstances and perspectives that an investor could have for a realistic number of questions to uncover. As such, when assessing Risk Capacity, the competence and diligence of the adviser will be the most important aspects of understanding how the capacity may affect a given investor and their goal.

The limitations set out above with regards to Risk Capacity seem fairly obvious, but they do not take away the value that a simpler Risk Capacity assessment can have. Such instruments rely on a small number of questions designed not to assess Risk Capacity’s every element, but rather the critical aspects that should be considered prior to investing. By exploring issues such as the existence of emergency funds, or the importance of the investment goal, these instruments can identify individuals that would be better advised not to invest, acting as a ‘knock-out’ component in the risk profiling process.

If a client has existing debts, for example, they need to be considered. It may be more pertinent for them to clear a personal loan rather than invest their available funds.

Considering that the broader aspects of Risk Capacity would still be left up to the adviser, Oxford Risk developed the Knowledge & Experience assessment which will provide the adviser with insight into the expertise of the investor. This measure is mainly used to as insight to the type of communication, explanation and consideration that the investor may require to be a part of discovering their overall Risk Capacity as they explore with the adviser the options available to them.


Knowledge and Experience Assessment

A robust and empirically derived measure of an investor’s K&E can be leveraged to qualify capacity for risk as the adviser engages with the investor.  Oxford Risk’s assessment consist of three direct questions that cover the ability to explain, previous and current experience with a series of commonly found investment types and the investment market in general. The responses place investors into one of four relative K&E categories (None, Low, Medium, and High).

All of the data gained during the process is used to place the investor on a relative scale of UK investors and is also included into future calculations. The advantage of this is that scale will be perpetually maintained to reflect current standards rather than relying on out-of-date information, which would render the calculation inaccurate.

As well as providing data for the algorithmic calculation, the Knowledge and Experience answers can also be used as part of a ‘knock-out’ process. An investor might be shown to financially secure but have no investment experience, which would be unsuitable for some wealth managers or types of products, for example.

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