We have seen lots of articles lately discussing capacity for loss.

    I thought it'd be useful to address this topic in the context of the other wider aspects of assessing a client’s attitude to risk.

    The starting point here is that knowing your client is paramount to establishing a client’s risk profile.

    While many companies offer tools that help to develop your client’s feelings about risk, the results should be used as a line in the sand in order to drive a conversation.

    This conversation, when combined with other details about your client’s life and objectives, can be used to establish the level of risk that's appropriate.

    The results of a risk profiling questionnaire will typically provide you with an indication of how risk-averse or adventurous your client feels they would like to be.

    This information, together with the client’s objectives, term, knowledge and experience and capacity for loss, should all be considered as part of the assessment.

    Let's take each of these in turn. 

    Objectives

    Objectives are individual, but can quickly help in the journey to assessing a client’s risk profile.

    For example, if someone is looking to invest £200,000 for a year before buying a house, it's clear no one would dream of suggesting the client invest this money in risk assets. 

    This is a clear example of where the client’s objectives would trump the result of any risk profiling tool.

    Term

    The investment term is another an essential ingredient when assessing risk.

    Taking the above example again, investing for the shorter term could mean the client doesn't have the ability to absorb market falls. The nature of market volatility is why anything less than a five-year time horizon is typically seen as being short-term.

    Knowledge and experience

    Establishing a client's investment knowledge and experience is another crucial component of assessing attitude to risk. 

    It's then about making sure the client understands the risks of investing as well as the advantages, taking time to explain the nature of the risk if they don't understand initially.

    This seems to have been largely ignored by the rogue advisers who descended upon Port Talbot in 2017, encouraging steelworkers to transfer out of their defined benefit pensions. 

    Many steelworkers were left believing that the promised returns of the new investments were guaranteed, and that they would ultimately be better off by transferring out.

    This saga, and the way client's understanding of risk had been ignored, led to the FCA introducing new rules for those advising on pension transfers to consider a client's attitude to transfer risk. 

    The rules include that advisers should consider a client's understanding of the risks of giving up safeguarded benefits for flexible benefits. 

    Personally, I think it's no bad thing to reiterate the need to talk to clients about how they might feel in later life not having a guaranteed income, or that they understand they will need to engage with an adviser each year to make sure their plans are on track.  

    We also need to consider the fact that there may be clients, particularly those in drawdown, where it becomes uneconomical to service them or where the agreed fixed fee stops being in the client's best interests.

    It's worth bearing in mind we don't glean our knowledge just from our own experiences, but also from the experience of others.

    We all know hammering a nail through your foot will hurt - not because we've necessarily experienced it ourselves, but because we've learned it elsewhere.  

    The source of our clients' investment knowledge needs to be explored. If they are basing it from what they've seen in the media, they may have an overly skewed or bleak outlook on markets, pensions and investing in general.

    Capacity for loss

    Now we come to the issue that's been dominating the debate recently. 

    Capacity for loss has clearly proved to be a divisive topic among advisers. 

    Taking a step back, the debate should be framed by the fact that the FCA is regulating to capture the lowest common denominator.

    What I mean by that is, while hopefully in the minority, there are some advisers who quite simply don't do the right thing by their clients.  

    Capacity for loss is just a consideration of what might happen should the value of an investment fall, whether this is on a temporary or permanent basis.  

    Some advisers have argued that capitalism will see markets continue on their upward trend in the long term. This may be true, but that upward trend won't take into account aspects such as a client's objective or term.  

    If we look at the performance of the MSCI World Index from December 2000 to January 2013, a client who made an initial investment in that time would have only seen their investment in positive territory for 78 months of a 148-month period. That equates to just under 53 per cent of the time.  

    It's true to say that a client is unlikely to be 100 per cent invested in global equities.

    But even a portfolio made up of an equity and bond mix over the same period would have been in negative territory for 53 of the 148 months, or 35 per cent of the time.

    There's no way of knowing that markets will be in positive territory when your clients need their money. So you have to consider the impact that a loss, whether permanent or temporary, has on your client’s risk profile.

    Overall, bringing all these pieces together is where the difficulty lies.

    Hopefully, I've explained my rationale as to why none of these assessments in isolation are enough on which to make a judgement. 

    All the different components, including capacity for loss, need to be considered and discussed in order to make sure your client knows the risks involved.

    Going through this process (and documenting this as you go) means you arrive at an appropriate conclusion that's best for your client. 

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