Assessing your attitude to risk is a mandatory part of the advice process. It is also, unfortunately, one of the most mishandled part of advising clients as this fascinating study, from the peerless Dr Greg Davies of Oxford Risk, shows.

It is a requirement of the regulator (the FCA) that an adviser must assess a client’s attitude to investment risk before investing. They want to see that the risk of the recommended investment matches your preferences to risk taking, your risk profile and ability to bear the risk.

Most advice firms interpret this as needing to assess risk attitude and risk capacity. The first is psychological and the second mathematical. Both are fraught with problems.

risk Attitude

Questionnaires are widely used to try to test each client’s attitude to risk, most of these questionnaires contain some profoundly silly (at best) questions such as ‘compared with your friends, are you a risk taker?’, as if risk is something that we all love to discuss over dinner with friends. The bigger issue, though, is one of adviser bias – the adviser who fills out the questionnaire with you will struggle not to influence the answers given (even through subtle tonal shifts when reading questions) and the adviser that leaves you to complete them alone runs the risk that you misunderstand what is being asked (Andy Hart describes these questionnaries as ‘Misconception Mirrors’ in this entertaining podcast on the subject).

In a former life, working for a bigger firm, we reviewed how our advisers had been assessing risk. The results showed that clients tended to cluster around different risk levels, adviser to adviser. This was a strange finding because each adviser looked after broadly similar clients and therefore Adviser A should have had a similar looking distribution of risk profiles across his clients as Adviser B. Whilst we never did the work to fully test my theory, it looked to me very much like the risk profile that a client had allocated to them by the adviser was more correlated to the adviser’s age, than any client factor that we could identify.

As an ethical adviser may tend to invest clients in a higher proportion of ethical investments, so to an advsier closer to retirement might tend to invest clients in a more cautious way. The only client I ever met that had invested in a Technology fund just before the 2001 Tech Bubble burst was advised by an individual who would arrive to meetings on a motorbike and brought his gun to show him. The client himself drove a Micra and enjoyed fly fishing.

There are a multitude of adviser biases that I have seen influence their clients’ risk outcomes; age, opinion of stockmarket levels, bad or good past investing experiences, lifestyle, children or none, employed or self-employed, married or single. You are battling with these biases before even starting on your own (and we are all a product of our experiences). This Cambridge University study for the Government’s Money Advice Service suggest that we have established our Money Attitudes by the age of 7.

Risk Capacity

This should, in theory, be possible to model mathematically as it is the loss that you can afford to experience and still achieve your target outcome. The problem is modelling this loss before it happens. You should never be investing any money on a time scale short enough that you don’t have time to recover any losses experienced (generally taken as 5 years). If this is true then you should have unlimited capacity for loss as the loss would always be recovered. To test anything else is to be forced to either assume no recovery from the loss (which is unrealistic and would likely force you to take too little risk) or that you need access earlier than planned which is a sign that the planning has failed.

We use Timeline’s cashflow modelling to assess how different historic investment conditions would have effected our client’s desired outcome. Where income is needed the same system assesses whether the likely maximum loss from the proposed risk level would reduce the desired income below ‘desired’ and more importantly below ‘necessary’. No system is perfect though and a risk of a reduction in income shouldn’t drive a client to invest with too little risk, thereby reducing growth to control a very unlikely but possible loss.

Missing Link

It seems that many advisers just opt for a risk attitude questionnaire and will crowbar you into one of five in-house portfolios depending on your score. Some of the better ones will attempt to assess your risk capacity and adjust the portfolio crowbar if this second test conflicts with the attitude score from the first test. Even using these two test together can miss a crucial part of the assessment. The need to take risk.

If you need to drive to Edinburgh by midday tomorrow you can’t adjust the distant but you can adjust the time you allow and the speed you drive. Likewise with investing towards a goal, you often can’t adust the time you have but you can adjust the amount you add and the risk that you take.

Some goals will require a certain level of risk to be taken to stand any chance of achieving it. In addition the effects of inflation on your goal are insidious, in that they are nasty and hard to spot. Human brains aren’t built to understand compound returns and it hard to fathom how much harder inflation will make a goal to achieve over a long time horizon.

The biggest risk is not taking any risk….In a world that is changing really quickly, the only strategy that is guranteed to fail is not taking risks.

Mark Zuckerburg, Facebook – Speech at STanford University Oct-2011

You need to take enough risk to beat first inflation to your goal and then the gap between what you are willing to save and you need to save. If the risk you need to take is too much for your risk attitude or risk capacity to take then something has to give. The trade-off will have to be a reduced goal (long-term pain) or reduced spending to allow more to be saved (short-term pain).

Finally the risk you take can’t be decided without taking into account your experience of investing to date and the risk of your current portfolio. You might be a ‘3of5’ investor but if you have never invested before or you are currently in cash, you might need to start by investing in a lower risk profile until you have some investing experience behind you and then slowly turning the risk up. This approach is probably fine in the Regulator’s eyes (it is impossible to know until after the fact) but needs very careful explanation, documentation and implementation. Andy Hart (mentioned earlier) has a more entertaining solution to this, he suggests increasing your exposure to shares by 5% per annum until you get to 80% equities. You can hear him, on the same podcast mentioned earlier, discussing this and promising to reduce his fees each year at the same rate.