When making an investment recommendation, it is important that we first establish a suitable level of risk.
This is the risk that an investor wants, needs and is able to take; the combination of attitude towards investment risk, financial planning goals and capacity for risk.
Our approach to assessing risk starts with an Initial Risk Assessment report.
We prepare one of these for every client before providing any investment advice. This blog explains how this report is constructed and what it contains.
Before constructing an Initial Risk Assessment report, we ask the investor to complete a simple questionnaire.
This asks 20 questions about attitudes towards investment risk, drawn up by leading psychometric consultancy, Oxford Risk. This is a company led by academics from Oxford University.
The questions we ask take into account a number of factors known to be excellent predictors of attitude to risk. These include risk sensitivity, time horizon, desire for profits, financial awareness, tolerance for ambiguity and investment experience, as well as other factors.
The answers to these 20 questions about risk attitudes have been shown to have a reliability of 92% in predicting attitude towards investment risk. This isn’t perfect (nothing is!) but provides an excellent starting point for discussion.
As well as assessing the answers to these questions, we consider the consistency of the answers. Any answers provided which are outside of the expected range are then flagged for further discussion.
In addition to attitude towards investment risk, we also consider capacity for risk. This is about your ability to take on investment risk.
We explore the impact that possible investment losses might have on your wider financial position, with some additional questions about your investment timeframe, capacity to tolerate possible losses and any liquidity requirements.
Once again, this is about creating a starting point for further discussion between the Financial Planner and investor, rather than confirming a specific position.
The answers to our questions about risk form an initial risk profile, on a scale of one to ten. This comes with a detailed description of what it means in terms of your level of comfort with the possibility of losing money on your investments and how much you want to invest in higher-risk investments to get better returns.
We then go on to illustrate what this risk profile means with some projections of a potential investment model over 1, 5, 10 and 20 years, illustrating below average performance and above average performance.
We provide a graphical investment forecast in the report which shows how a portfolio consisting entirely of cash might grow if it were invested according to our strategic asset allocation model.
We also plot the proposed investment model for your initial risk profile on an ‘efficient frontier’ chart, which shows the relationship between risk and reward.
Our Initial Risk Assessment report concludes with some further discussion points for the Financial Planner and investor to work through together when they meet.
We believe that this approach to the assessment of investment risk is very robust and puts each investor in the best possible position to make suitable investment decisions, as well as providing our Financial Planners with a good framework for making suitable investment decisions.
