Balancing risk and reward

Most people like to think they are risk-takers but when it comes down to it, the prospect of making one heap of all their winnings and risking it on one turn of pitch-and-toss tends to bring out the coward in us. This is one of the reasons investment firms employ quite sophisticated methodologies to assess people’s true appetite for risk.

Davy private clients director Gareth McCluskey notes the requirements on investment firms have become even more rigorous since the second EU Markets in Financial Instruments Directive (MIFID2) came in to force at the turn of the year. “We are now compelled to do a risk questionnaire to establish an investor’s appetite for risk,” he explains. “It asks a lot of very serious questions. At what point do you start feeling uncomfortable with losses, for example. A lot of people say they love risk but when you ask them the questions it is different.”

According to McCluskey, there are three ways to assess risk: attitude – to find out how people really feel about losses; appetite – where an investor is asked how much they would be willing to invest and lose; and capacity to take risk – how much they can afford to lose.

The investor may well have a positive attitude and a healthy appetite for risk, but they may simply not be able to afford losses because of their financial position. On the other hand, they may have the resources to withstand relatively heavy losses, but their attitude is such that they should not be exposed to that hazard if at all possible.

Past performance also has an influence on what people perceive to be their risk appetite. “A good example is where a client comes in having seen good returns for the past few years and thinks they can take a risk on that basis. They might have the capacity, but do they have the appetite? This can lead to some tough conversations with clients. Sometimes we have to talk them off the ledge. That is what investors demand from their financial advisers now.”

Difficult concept

Investec investment manager Dan Moroney says risk is a difficult concept. “Sometimes the investment industry steers people down the wrong path when discussing it,” he says. “The main mistake is to think narrowly in terms of volatility. If your investment is short term, you have to think seriously about volatility. But most investors have very long-term horizons. Pensions go all the way to retirement and most probably beyond when people invest in an approved retirement fund after that. To think narrowly in terms of volatility in these circumstances could result in poor outcomes.”

He points to an example of how such thinking can lead to a negative outturn. “A 45-year-old with a significant proportion of their pension fund in cash and bonds will have a real risk of not having sufficient money to fund a comfortable retirement when they are in their 60s and 70s.

“That underlines the importance of professional advice,” he continues. “You need a diversified portfolio. One or two of the assets can go down and never come back but if the portfolio is sufficiently diverse, the other assets will more than make up for that. The type of asset that goes up and down in the short term tends to be the one that delivers the best long-term return. People have to put aside concerns about short-term wobbles when it comes to long-term investments.”

But he does acknowledge that this might be easier said than done. “People need to ask themselves how they would react if their equity investments fell by 20 or 25 per cent, which isn’t all that unusual. If you are not able to accept this, you will probably sell at the wrong time. We are not robotic, we have human responses. That’s why it’s so important to have a professional adviser who can advise on the reality of investment.”