The Question Behind the Client Risk Questionnaire

Risk questionnaires tend to compress several different risks into a single score.  This can obscure the relationship between the return a client needs, the volatility they are willing to tolerate and the time available to achieve the objective.

Risk Wears Many Hats

Part of the problem is that the industry uses one word for several distinct concepts, and the risk it can measure most easily is not always the one that matters most.  Risk can mean:

• Volatility, or the tendency of a portfolio to move up and down.  It is measurable, usually felt over short time periods, and it is what most risk questionnaires and risk management systems capture.

• Permanent loss of capital, which is a different matter entirely. A holding which falls and later recovers has caused discomfort; one that falls and does not recover has caused permanent damage.

• Loss of purchasing power, the slow and largely invisible erosion of what a sum of money will buy.  Cash rarely falls in nominal terms but frequently falls in real terms.

• Failure to meet the investment objective, which is arguably the only risk which truly counts, and the hardest of the four to put a number against.

Unfortunately for clients, these different ‘risks’ do not point in the same direction.  The measures taken to reduce one of these risks can increase another.  Reducing short-term volatility may increase the risk of losing purchasing power, while seeking a higher long-term return normally requires accepting greater variation in value along the way.

The Cost of Risk

A larger allocation to cash and high-quality bonds generally indicates that reducing short-term volatility is being prioritised.  This is because cash and bonds typically offer a less volatile experience than equities.  This may be entirely rational, particularly if the client’s temperament is not suited to short term volatility, or the investment time horizon is short.  However, the cost of this decision isn’t easily visible in advance.  

For illustration only, assume that two portfolios start with £100,000, earn constant annual returns of 4% and 6% respectively, and incur no withdrawals, fees or tax.  The difference in future value between the two portfolios is an indicator of the cost of thinking about risk as volatility, rather than as a future shortfall.  Because returns compound, the potential shortfall increases with the time horizon:

Importantly, because the cost is paid in final value and is exacerbated by time, the exchange rate between the two types of risk (volatility and future shortfall) is the time horizon.  A client focused on paying school fees over the next five years pays a significantly lower shortfall cost for reducing volatility than a client aiming to maximise a grandchild’s inheritance in 25+ years, even though they may describe their appetite for risk in identical language.

None of this is an argument for taking more risk, but it is an argument to try to consider the cost of reducing volatility risk over other types of risk.  A client who understands that a more cautious arrangement may reduce the eventual value of an estate, and chooses it anyway because sleeping well matters more, has made a perfectly sound decision.  A client who chooses the same arrangement having never been shown the trade-off has not really made a decision at all. 

Questions Worth Asking

The discussion with an investment manager or financial adviser should therefore focus on the following questions, rather than only on comfort with a hypothetical fall in value:

• What is this money for?

• When will it be needed?

• If markets fell sharply, would the client be forced to sell?

• What matters more, avoiding short-term loss or failing to reach the long-term objective?

There are no universally correct answers, only answers which are consistent.  Objectives, risk and time are not three separate items on a form.  They are one decision viewed from three angles, and a change to any one of them alters what is achievable in the other two.  A client may reasonably want the lowest volatility, or the largest possible future value, or access to their capital at short notice.  Wanting all three simultaneously is the one position which cannot be achieved.

CDAJ

Risk Warning & Disclaimer

This article is provided for general information purposes only and is not intended to constitute investment advice, investment research, or a personal recommendation. It does not take into account the investment objectives, financial situation, or particular needs of any individual or entity.

The views expressed are those of the author as at the date of publication and are subject to change without notice. The material is the original work of the author. It may not be copied, reproduced, distributed or presented as the work of another person without his prior written consent.

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The value of investments and any income derived from them may fall as well as rise, and investors may receive back less than they originally invested. Past performance is not a reliable indicator of future results. Where investments involve overseas assets, returns may be affected by movements in exchange rates.

Ptarmigan Capital Limited is an employee-owned investment management firm providing discretionary investment management services to private clients, trusts, charities, and family offices. This article is intended to explain the firm’s perspective on bespoke investment management and the factors some clients consider when choosing such an approach. It does not relate to any specific investment product or strategy.

Ptarmigan Capital Limited is authorised and regulated by the Financial Conduct Authority (FRN 940407). Registered in England and Wales (Company No. 12715470). Registered office: 17 Cavendish Square, London W1G 0PH.