For financial advisers, assessing Risk Capacity, the retail investor’s ability to bear loss, is a regulatory and practical necessity once Risk Tolerance is established; both are key elements of the investor’s Risk Profile.
Author Andre Correia
Date 7th October 2016
Risk Capacity is the extent to which an individual can, largely tangibly, cope with potential losses, having considered their financial circumstances and the aims and aspirations that comprise their investment objectives. Risk Capacity, unlike Risk Tolerance, often varies with the wealth and goals of the individual, thus investors with the same Risk Tolerance may have different Risk Capacities, which for that investor may also vary goal by goal.
Considering the innumerable set of circumstances, ambitions and restrictions that may define an investor’s Risk Capacity, care must be taken when creating an algorithmic process to assess Risk Capacity. ‘Noise’ in the data might overcome the ‘signal’ leading to spurious accuracy and inconsistent results. Moreover, there are far too many variables that could affect Risk Capacity to confidently address through a short questionnaire. However, the challenge of assessing an investor’s Risk Capacity remains crucial to determining a suitable investment strategy. Oxford Risk maintains, that addressing Risk Capacity dynamically and iteratively, using appropriate levers and the most meaningful proxies, is the best approach.
In traditional adviser-client situations, a detailed discussion with the investor would allow the adviser to understand the fundamentals of the investor’s Risk Capacity. A good advisor, aided by due process, will instinctively tease out the investor’s Risk Capacity during their conversations. How then, can a Risk Profiler add to due process, assist the adviser, and help the investor to better understand their own preferences to then make an informed investment decision?
Oxford Risk’s approach, which has been adapted and applied to different types of investment services, relies on two components: Ensuring adequate minimum capacity, and facilitating consistent engagement:
- Notwithstanding the limitations of questionnaires when assessing Risk Capacity, there are some aspects of a person’s capacity to absorb losses that can be assessed to check the investor has a minimum level of capacity to support any new investing. A simple questionnaire can addresses common concerns such as the level of personal debt, access to funds to cover an emergency, or the preparedness to invest for a sufficient time horizon. Typically, the output will be a yes/no adequate or inadequate score, that serves as an ‘exclusion’ mechanism in the Risk Profiling process
- For those investors with an adequate minimum level of capacity, a detailed consideration of their circumstances and preferences will follow. For success, this process requires that the investor has investment priorities and can articulate their goals, expectations, and the constraints that will determine what in the end is a suitable investment. Optionally, Oxford Risk provides consulting services when clients implement Risk Profiling, offering guidance on best practices that enhance the effectiveness of investor engagement. We would help develop descriptions and scenarios in language and terms that the client’s retail investor would understand. Similarly, when offering comparisons between the expected performance of alternative investments, or where there is cash flow planning, Oxford Risk has significant expertise in presenting the alternatives to ensure the investor understands the choices and trade-offs they face. The research conducted by our academic contributors, at the University of Oxford and beyond, have proved invaluable and led to significant research collaborations, including projects with the Bank of England.
This investor engagement, determined as it by the business model, can vary from client to client, and between face-to-face and online investment services, though the key considerations remain the same: can the investor reach an optimal and informed decision, having considered their priorities, goals and expectations, and their constraints, and choose from the alternative investments that offer a suitable level of risk and reward for them?
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