In general, the higher the risk people are willing to take with their investments, the greater the potential return. But people are often uncomfortable with the volatility that comes with stock market investments. How do you calculate your risk profile and try to ensure your savings are growing while not giving rise to sleepless nights?
Risk profiling is the first step in establishing an investor’s risk tolerance but that is only the beginning.
Ian Quigley, head of investment strategy at RBC Brewin Dolphin, uses a survey and questionnaire to establish his client’s investor status; however, this is just part of a tool kit he uses to help him advise clients, he acknowledges.
“Typically we look to establish if there is a five-year investment strategy. That’s because when we look at the equity market, for example, it’s not unusual to see a 20 per cent decline – and sometimes even bigger,” says Quigley, citing the financial crash as an example of a period of significant market downturn. “Last year was also tough, with mid-20 per cent declines, so we need to have eyes wide open for what can happen.
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“People react differently to market movements so we need to ensure that they are not spooked by a short-term correction. If you want to maximise return over the long term, you need to be prepared to see both negative and positive movements. But in the long term and over the great sweep of history, equities tend to offer around 6 per cent over inflation returns.”
Andy Dixon, head of business development and marketing at Harvest Financial Services, also sees the survey as a good starting point.
“We view it as a tool to start a conversation. These psychometric questionnaires typically deliver information indicating the client’s position on risk, looking at their capacity for loss, their investment experience, the types of assets they’ve invested in the past and what they can afford to lose,” says Dixon.
Test results typically come in the form of a number, which is the basis of a broader conversation.
“A client may be a cautious investor but, after conversations, we might discover they can only afford to put away the money for two to three years – then that changes the conversation,” says Dixon.
“The results are really only a starting point – from our perspective, the most important thing is the investment time horizon.”
For Dixon, three years is his key time frame. “If the client is not looking at an investment time of at least three years then we say stay in cash. That could be in the form of fixed-term deposits, as opposed to a demand account.
“And if you have at least three years in hand, then we can look at equities, as you have time to ride shorter-term volatility,” says Dixon.
When looking at putting together a portfolio, predictions of future growth can only really be done through viewing historic performance, the prevailing valuations of assets at the time and reasoned assumptions. Quigley points to historic charts as giving a guide to future movements. When investing over the short term, returns can be very high or low – there can be great discrepancy, depending on the markets.
“However, as the investment horizon stretches out, these ranges contract,” he says. “When you get to five years, this range tightens up and this continues over longer terms of investment. If you explain this to your client they are less likely to make uninformed decisions. For example, a common mistake might be to realise losses and to switch to, say, cash or fixed deposits. If the client has time, then we would expect their position to recover.”
Quigley adds: “The last year or two has been more challenging for lower-risk strategies, with many bonds down on their 2021 highs and the general market is only recovering now. You need your eyes wide open when investing in equities as you will get tested along the way. That’s why those conversations are so important at the start.”
Aside from investor risk tolerance, there is also the issue of short-term volatility versus long-term growth. Short-term volatility is the price you pay for any potential long-term capital growth.
Trevor Booth, head of retail sales with Mercer, also views the initial risk assessment as a starting point.
“We make sure our client understands the potential volatility of the investment vehicle,” says Booth. “Short-term volatility shouldn’t be a concern if you don’t need to access the funds. A 40-year-old investor in pensions can be more tolerant to short-term volatility.
“Investment decisions are driven by the timeline of the investment: the shorter the time frame the less risk you are likely to take on – for example, if you need to access the money in few years for a child’s education needs.”
Dixon stresses that it’s not just about investment risk. He likes to ask his clients what they are trying to achieve.
“Do they want to receive a certain amount of income in their retirement or to achieve a capital growth that is greater than available on deposits? Or do you just want to maintain the real purchasing power of your wealth?”
He also underlines that not taking on investment risk is not a zero-risk decision.
“If you factor in inflation – and take the more extreme inflation of current years – a cash amount of €100,000 would only be worth €50,000 in 12 years’ time. Inflation risk is real – it can be a silent erosion of your wealth.”
Then there are planning decisions associated with retirement when the person is net removing money from their investments. Dixon points out the investment decisions still need to be made – without the comfort of an income.
“Some clients sort of take the attitude that I’m going to roll my money down until I’m 90, at which point I am somebody else’s problem, where other clients are more concerned about estate planning. Those conversations can be pretty interesting,” says Dixon.
Ultimately, Quigley does not advocate penalising people for changing their mind.
“We take the position that everything is liquid and the client can access their funds at any time without penalties. We believe this gives our clients peace of mind,” he says