Has the reward chasing peak been reached?
Author Andre Correia
Date 15th December 2016
Risk preferences, or the absolute level of risk an investor wishes to take, have long been the subject of significant discussion. Can they be calculated? Is there a more consistent approach to observing preferences than the traditional reliance on the adviser’s expertise? Do preferences change, and do they relate to risk tolerance?
Since launching our suitability analysis – or Time Dimensioned Risk Preferences analysis – in 2011, Oxford Risk has been able to document investor preferences, and answer the questions above and more.
The more pertinent answer – can they be tested? – has resoundingly been demonstrated to be affirmative, although not without its challenges. Preferences can only be expressed as a choice between diverse scenarios that in themselves are markedly different and provide a clear indication of a risk prone or risk averse decision. Ensuring investors, or samples of would be investors, are able to identify their preference between diverse investment choices relies on their ability to understand the risk/reward characteristics of those choices. By positioning potential investment outcomes visually, typically with a ‘banana’ graph, the majority of investors is able to differentiate between two alternatives, without relying on numbers, fractions or percentages – which can be commonly misinterpreted by the average person.
The ability to allow an investor to make choices between investments, leads to an important second challenge: what investment group should they be selecting from? The delivery of risk can be achieved through a variety of investment types, ranging from the plain vanilla to the asymmetric risk/reward relationship that can be obtained with structured products. Whether or not the assumptions linking risk profiling outputs (tolerance/capacity) to a suitable level of risk are accurate, the question remains, what investments should be tested as part of discovering preferences? In this instance, the pragmatic approach is seen as the industry best practice. Calibrating investment preferences should be based on providing a choice between alternatives that offer the same risk/reward characteristics as the actual investments the investor will have access to through the advice process, or the online investment service. In this manner, a choice between risk level 1 and 2, can more accurately reflect a preference between those two real life portfolios, allowing for a closer alignment between the expectations of the investor and the expected returns of the selected investment.
With the above challenges met, we are left with a clearer understanding of where investor risk preferences lie, and how they change overtime and react to the market sentiment and the economic circumstances. Oxford Risk has been conducting research on investor risk preferences since 2011, ahead of the New Year, we look back on the identified trends for investor risk taking preferences.
At the start of 2016, UK investors had been displaying more aggressive risk taking behaviour, particularly at the high end of the Risk Tolerance scale. Such a trend was largely to be expected, as from 2011 to today we have been moving away from the period of very high volatility and uncertainty that investors lived through during the 2008-2010 financial crisis. At that time, on the back of substantial underperformance, investors were more focused on avoiding losses rather than chasing reward, and as such exhibited a lower preference for risk. As time moved on and markets recovered and stabilised, the focus on reward gained importance which translated into a gradual increase in the risk-taking behaviour. This increase made a significant difference to the consideration of what investment would be suitable for each tolerance category, as the years progressed. For example, for a standard risk/reward level in the UK, risk preferences for the most risk averse investors investing for 5 years, changed from 2.5% to 4.5% volatility. What that reflects is that within the 2011 to 2016 period, the same low risk tolerance investors would have almost doubled the volatility they would generally prefer even with an unchanging proportion of reward expected in their investment. This increase highlights the importance of continually measuring investor preferences, due to their dynamic nature, to ensure that the suitability of advice is always informed by the latest trends in the preference for risk of investors.
By the summer the trend of increasing preferences had stopped, and risk preferences showed no change from the early 2016 values. Performance, however, remained positive with returns beating previous estimates, particularly in the stock market. This pause in the increase of risk preferences would therefore seem to be linked to the main external event that has come to be a defining moment in 2016: the Brexit vote.
In the run-up to, and the after math of the referendum, studies looking into the emotional outlook of the UK population came up with a similar review. Pre and Post 23rd of June, Brexit was the dominating concern in the UK. Whilst some individuals demonstrated optimism in the eventual political execution of the vote, the greatest ‘unknown’ remains the new status quo – what will Brexit look like, and what impact will it have on the economy, the political stability and the relationship with the EU? With no short-term answer to any of those questions, the uncertainty could be the factor behind the unchanging risk preferences. This hypothesis is further reinforced by the fact that the weaker value of the GBP after the vote made the UK stock market perform very well, as FTSE100 companies in particular benefited from a higher value of their non-UK income. Despite the improved performance of equities, risk preferences were stable.
2017 will be a very interesting year as it will reveal the effect of the major political events, such as Brexit, on investor risk preferences. If the uncertainty is followed by an overall loss of confidence, or performance, we could see preferences for risk decrease for the first time since the end of the financial crisis. Furthermore, regardless of how preferences are affected, any change at all will bring some clarity into how the retail investor population reacts to external events. Oxford Risk has been in the privileged position to monitor preferences for the last 5 years of a slow return to confidence, and now if confidence turns or falters, or with greater impact if the economic cycle turns, we will learn how quickly and drastically investors react to the new environment. Whilst all of us in the industry would prefer a period of sustained confidence and stability, if 2017 brings a different scenario, Oxford Risk will be ready to interpret all events as they unfold.
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