It’s not always easy as an adviser to help clients navigate the risks they face in managing their money.
Understanding how these risks support or conflict with your client’s ambitions is a key consideration.
In creating a strong and robust plan for a client we usually consider three dimensions of risk:
1. the risk they would prefer to take;
2. the risk they can afford to take; and
3. the risk they need to take.
The risk they would prefer to take
This the psychological dimension; how easily will clients sleep at night and how will they react if market movements lead to swings in their fund value.
There are many attitude-to-risk (ATR) tools that can help an adviser to frame and characterise their client’s inherent risk appetite.
The risk they can afford to take
Also known as capacity for loss, this factors in other assets beyond the specific funds that are being considered for investment.
These might be additional reserves of capital or sources of income, such as a defined benefit pension.
This requires a balance between taking different levels of risk within each investment, and remaining consistent with the client’s overall risk appetite.
The risk they need to take
This is the translation of the client’s circumstances to the level of risk required to achieve their goals.
Often a goal cannot be achieved without a certain level of expected return, and this will largely determine the amount of risk that must be taken to have a reasonable likelihood of achieving the goal.
What, then, is the right amount of risk to take, and which portfolio can best achieve it?
These questions can be answered by modelling the cashflow requirements alongside economic projections that allow for the risk characteristics of the portfolios being considered.
Managing risk and client expectation
These three dimensions of risk can often conflict with each other.
For example, the ATR score may indicate the client is naturally quite risk averse, but their goal is challenging and requires a high expected return (and therefore risk) to be attainable.
An analysis of their capacity for loss suggests they could bear at least some of the increased risk, since they have other sources of income which could provide most of their minimum income needs.
That being the case, what should they do?
Stick with the original goal and invest at a risk level higher than their natural risk preferences? Or invest in line with their natural risk preference and lower their ambitions? Or somewhere in between?
There's no single correct answer, and suitability depends on the client's individual circumstances.
By equipping yourself with the right tools and products, advisers should be well-placed to engage with clients and help them navigate the trade-offs needed to craft a sustainable and achievable plan, one that balances their three dimensions of risk.
Bridging the risk gap
Risk, particularly attitude-to-risk, creates a narrow definition of investment risk that doesn’t take account of the client’s desired outcomes.
Simply working through an ATR questionnaire and choosing a fund consistent with the resulting score doesn’t provide a complete picture.
Instead, we need a more rounded way of assessing risk that converts abstract investment metrics, such as volatility, into the risk of not achieving the outcome.
After all, the client is investing to achieve a goal, not satisfy their risk appetite.
Using the client’s goal, what is it they want to achieve with their money?
By working backwards from their desired outcome, we can test potential portfolios to understand which offers the best balance between risk and opportunity.
One approach is to include measures such as goal likelihood, proportion of goal achieved and one year forward projections, as well as potential returns over the first year and the spread of fund values in the long term.
By comparing these values for different portfolios, advisers can have more nuanced client conversations about which portfolio provides the best balance, using language and figures that describe the situation in terms of the goal the client wants to achieve.
If the trade-off between the different risks isn't acceptable, then it also supports a discussion around amending the goal itself: portfolio choice and goal definition aren't independent, one impacts the other.
The starting point for any successful financial plan is a realistic goal, and this can be turned into a robust plan by considering the three dimensions of risk.
Traditional attitude-to-risk analysis answers the question of how much risk the client would prefer to take, but doesn’t offer any insight as to whether their plan is consistent with the risk they can afford to take, or that they need to take.
Advisers should consider how they can bridge this gap, preparing the ground for engaging client conversations on risk.