Key points

  • If you start with high risk capacity, then after a fall in the markets your capacity gets even higher. If you start with low capacity, then lower market values means an even lower capacity. If those changes are large enough, then the risk profile could change enough to justify a portfolio change.
  • If you’re taking withdrawals but happen to have a high risk capacity, you needn’t worry: market falls become an opportunity to increase risk, not something to protect against.
  • Whether the investor is in the position of a market fall being a threat, an opportunity, or a matter of total indifference, the answer to what to do should be systematic: clear, concise, and calculated; it is driven by risk capacity.

When markets move, should investors move with them?

Markets have fallen. A client calls their adviser. On their lips, a question perhaps as common as they come: what should I do?

Some will want to sell in panic, fearing a further fall. Others will want to buy, to seize the opportunity of knock-down prices.

Whichever way their speculation is swinging, there’s a temptation to think it must boil down to each investor’s attitude to risk.

The adviser, knowing that the client’s psychological willingness to take on long-term investment risk hasn’t changed, counsels the client to sit tight. Don’t overpay for short-term emotional comfort. Don’t try to time the markets. Reduce the risk and you miss the recovery. Increase the risk and you’re being reckless; what do you know that the markets don’t? 

Doing nothing is an easy answer, and in many cases, it will be the best course of action. But is it the end of the story?

Probably not. Especially if the client is contributing to or withdrawing from their portfolio. Sometimes, a change in market values should lead to a change in a client’s risk level.

Willingness to take investment risk is one part of a risk profile. The other is the ability to take that risk. And it is that – the client’s risk capacity, that determines what they should do. No guessing. No gambling. And no relation to in-the-moment opinions of market movements.

The importance of a quantified and dynamic measure of risk capacity

Risk capacity answers the question: what level of risk can I afford to take with my investible wealth right now, given my current circumstances and future aspirations? It tells us to what extent an investor relies on their investments to fund their lifestyle.

If you start with high risk capacity, then after a fall in the markets your capacity gets even higher. If you start with low capacity, then lower market values means an even lower capacity. If those changes are large enough, then the risk profile could change enough to justify a portfolio change.

This is because risk capacity has a multiplier effect upon risk tolerance in the calculation of a risk profile. If capacity is neutral, the risk profile will match risk tolerance. Go far enough above neutral, and the risk profile moves up a level (depending on behavioural constraints). Go far enough below, and the risk level goes down too.

This approach therefore tells us what change to make to a risk level when markets fall:

  • If risk capacity is above neutral, the investor is not reliant on their investments to fund their lifestyle, so a drop in market values means that investible assets now make up an even smaller element of total net wealth. This means they can afford to take more risk with those investible assets.
  • If risk capacity is below neutral, there is more reliance on investible assets, so a fall in investment values makes it more difficult to fund future cash flows. To protect their already low ability they should take less risk.

When reactions interact with proactive planning

An additional dimension is provided by other planned portfolio changes. How should changes in risk interact with a withdrawal strategy or rebalancing?

Most investors taking withdrawals have a below-neutral risk capacity: the withdrawals indicate they are reliant on their investments to meet their expenditure. If you’re taking withdrawals but happen to have a high risk capacity, you needn’t worry: market falls become an opportunity to increase risk, not something to protect against, because your protection comes from whatever is providing your high capacity (for example having high home equity).

In either case, because risk capacity changes with portfolio value changes, when it’s suitably calculated and built into the solution, it provides automatic management of withdrawal strategies, including combating sequencing risk.

It is worth noting that this is the case only with fixed future cash flows (withdrawals or contributions). If the investor is instead able to simply spend less when markets are down, and to spend more in good times, this has the same effect as adjusting risk capacity; the ability to flex spending enhances risk capacity. In practice it may often be easier to adjust spending than change a portfolio, especially in the absence of a risk-capacity tool that does all the calculations for you, such as Oxford Risk’s.

Though rebalancing is also a reaction to changes in markets, unlike market timing, rebalancing is a proactive, pre-planned reaction, and it represents restoring a risk level, not changing it. It therefore shouldn’t necessarily concern us here. However, where there are contributions or withdrawals happening at the same time, there is value in not treating the processes independently. Much rebalancing can be achieved simply by ensuring that withdrawals are taken from overweight asset classes, and contributions are made into underweight asset classes.

Rebalancing is smart. Rebalancing that accounts for changes in risk capacity is smarter.

Bringing meaning to market movements

Whether the investor is in the position of a market fall being a threat, an opportunity, or a matter of total indifference, the answer to what to do should be systematic: clear, concise, and calculated. As so often in financial advice, it’s not the answer that counts so much as the reliability of the process that got you there.

To return to our opening question: when should a fall in market values lead an investor to change the risk level of their portfolio?

When those changes are made as an attempt to time the markets, they shouldn’t.

When those changes are made automatically as a reflection of our calculated ability to take risk with our portfolio, they should. If our risk capacity is high, this could mean taking more risk. If capacity is low, it could mean taking less. A quantified and dynamic risk capacity calculation provides the framework to remove the guesswork and get to a robust and reliable answer.

Originally published in Professional Adviser on 18/2/2019.