As explored in a recent article, ‘The Challenge of Assessing Risk Capacity’, we explored the overall difficulties of assessing Risk Capacity, and the limitations of algorithmic risk profiling instruments.
Author Andre Correia
Date 19th October 2016
Risk Capacity is the extent to which an individual can cope with potential losses, having considered their financial circumstances and the aims and aspirations that comprise their investment objectives. It differs from risk tolerance in that the ‘coping’ in this case is not only subjective and figurative, but tangible; “How much can you really afford to lose”, or, to put it as an upside, “How much can you really afford not to gain”. Considering how varied those circumstances may be, or the personal bias in how they may be perceived by an investor as constraints or degrees of freedom, makes the questionnaire based assessment of Risk Capacity an insufficient approach, as it would offer spurious accuracy and an incomplete view of the ability to bear loss.
Whilst short questionnaires can prove useful, for example to identify investors who may be eligible to be ‘knocked-out’ of the advice process due to a clearly insufficient capacity to absorb losses, the process needs to be strengthened through engagement. This can happen with an advisor in a face to face meeting, or through a web portal in a non-advisor online investment service.
For the past several years, Oxford Risk has conducted research with behavioural econonomists in Oxford University to ascertain what are the most effective methods to engage with an investor and get them to effectively consider circumstances affecting their Risk Capacity. This article explores some of the key learnings from this work which apply to engagement processes across the UK. This article focuses on the presentation of investment choices when engaging with an investor, to consider their circumstances and options in light of their specific Risk Capacity.
• How should information be presented to ensure investors understand the consequences of their choices?
How to present information to eliminate as much bias as possible, and be understood by its investors, is one of the greatest challenges of ensuring a suitable investment is selected, and that Risk Capacity constraints and preferences are taken into account.
Oxford Risk used research to establish the comprehension of investors when presented with information in different formats. The objective is an approach that is suitable for investors with varying degrees of experience in investing, and familiarity with the terminology commonly used by advisers/fund managers. In our experience the use of visual aids, such as potential outcome (banana) graphs, is more effective than descriptions, numerical or otherwise, since many investors aren’t familiar with specific terminology and may have poor numerical skills. A graph or animation itself presents challenges, and some explanation will still be required, but it is on the whole easier to understand the representation of investments visually, and most importantly understand uncertainty and variation in outcomes.
Once the expected performance of a possible solution is presented to the investor, a range of simple explanations can be used, to focus the investor’s attention on some of the key questions about their Risk Capacity.
Figure 1 - Illustration of the Potential Investment Performance for a Portfolio, for a 4yr time horizon investment goal
- What is the maximum fall in value the investor is willing to accept in the short-term (i.e. 1yr)?
- What is the required certainty of outcome for the investment?
- Is there flexibility in the time horizon, and investment amount?
The three questions above are good examples of queries that can be posed to investors to align their choice to their circumstantial capacity for risk. By considering if the presented potential loss of value in the short-term is acceptable (Point 1), or if the median and/or top and bottom percentile return expectations deliver an adequate return (Point 2), the investor can begin to align the expected performance to their own expectations.
If the presented investment is not suitable when these questions are posed, the investor (with or without an advisor) can then consider how best to find a suitable alternative, either through increasing/decreasing the level of risk, altering the initial investment, or altering the time horizon. This process is crucial to identify when a seemingly suitable investment (identified on the basis of Risk Tolerance alone), may not be suitable with the specific Risk Capacity of the investor. It makes the advisor/investor relationship a more involved and holistic one, a process rather than a series of inputs-outputs.
In addition to presenting Risk Capacity considerations, the investor can be presented with an example of an investment’s historical actual performance, rather than the banana graph that indicates the average of expected potential performance. In Figure 1 above, such an example is represented by the blue line (Point 3). This representation can illustrate how their particular investment may at any point in time drop below or climb above the expected returns 90th and 10th percentiles averages shown in the typical banana graph. In turn, this will allow them to consider that perspective when deciding for example what level of maximum loss they might be willing to accept. It may make them question their risk tolerance, another useful interaction in the advice process.
Overall, there are many questions and engagement techniques that have been effective at enhancing the value of the engagement with the investor, and support the assessment of their Risk Capacity. Implementations of these processes vary across countries, cultures, providers, solutions and interfaces, and Oxford Risk is happy to explore any insight which may be relevant to your Risk Profiling process. To find out more, please get in touch.
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