Risk suitability assessments must account for vital factors

Analysing UK investor preferences is a complex process which we manage very closely

Gillan Williams
Author Gillan Williams
Date 6th September 2016

Risk Tolerance, or the Attitude to Risk, is a relative and stable measure. The outcome is a useful first step in understanding how comfortable an investor is in relation to their peers. However, whilst Risk Tolerance is unlikely to change significantly over time, our research shows that Risk Preferences are subject to more pronounced short-term changes. A good scenario showing this would be to consider a risk averse investor, and their preferences for risk during the financial crisis of 2008 onwards. In those years, their tolerance will have remained at the low end of that relative scale, but the risk they would have preferred in 2007 versus the subsequent years will change drastically in that period, as they reacted to the general market sentiment and possible personal losses in existing investments. Naturally in periods of continued stability, risk preferences increase, but yet again risk tolerance is unlikely to change during these upturns/downturns.

This fact has a substantial impact on assessing an investor’s Risk Suitability. Suitability encompasses much more than simply aligning Risk Tolerance with portfolios segmented according to volatility and expected return. There must be a deeper understanding of how preferences change over time, and how the trends are likely to drive preferences looking forward. No matter the merit and accuracy of any suitability analysis, it will undoubtedly lose accuracy over time if it is not kept up to date.

As an example of this, over the last few years we have observed that, in general, investor’s appetite for risk has increased. The acceptable volatility range for investors with low Risk Tolerances could be up to 2% higher than four years ago. The result is that investment options that were once correctly aligned should now be considered too conservative and would not deliver the potential returns desired.

Another important element to consider is the time scale. By aligning investment volatility and expected return directly with Risk Tolerance without considering the desired time scale of the investment, an advisor would not know which options could return suitable yields within expectations. For example, a 20 year retirement investment has time to recover from poor market performance, and hence preference for risk would be higher when compared with a 3 year investment. Without determining the time scale of the investment, and the investment goals, the investor’s short-term loss aversion or focus on long-term reward seeking could be improperly factored into a suitability analysis.

Analysing UK investor preferences is a complex process which we manage very closely. Amongst many factors, our risk profiling system tracks prevailing investor preferences and the data output clearly shows which levels of return, grouped by their Volatility Range, align with the investor’s Risk Tolerance.

An accurate suitability assessment must be able to factor such issues. It is our belief that such matters must not be subject to assumption. Assumptions here lead to inaccurate advice and undesirable results for investors and managers as well as regulatory problems.

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