What is Risk Profiling. It’s a real minefield

By simple definition, risk alludes to the possibility of a number of different outcomes that arise as a consequence to a given action.

Often, investment academics will usually associate risk with the volatility associated with the costs and returns of an investment.  Volatility is measured as a standard deviation – how far something moves from its average i.e. the higher the standard deviation, the greater the risk (risk can be to the upside as well as downside). Typically, lower “risk” portfolios will have lower volatility than their higher risk counterparts. Indeed, this is how a lot of financial professionals tend to measure risk.

However, a client’s concept of ‘risk’ and how the investment industry depicts ‘risk’ can contrast considerably. This can prove to be a challenge for advisors; especially if they choose to focus exclusively on quantitative measures of risk such as volatility. Broadly speaking, just reviewing risk in terms of volatility is complicated as clients tend to not think in terms of narrow mathematical terms. Often, a client will be reviewing risk as the anticipation of an unattractive outcome such as not achieving an investment objective or suffering from a financial loss.

In fact, clients face several risks and it is imperative that a financial advisor can express this to their client. Risks includes inflation and/or shortfalls and changes in the economic and political landscape. Inflation is a sustained increase in the cost of living and general price of goods in an economy over time. Over time, inflation eats away at the value of money and a client loses purchasing power.

Asserting the risks of inflation is important as some savings vehicles fall flat when it comes to paying a return that beats inflation. Shortfall on the other hand is the risk of being unable to meet a long-term investment objective. Shortfall can occur if an investor doesn’t take enough risk to achieve higher rewards. At the same time, investors could be subjected to shortfall risk if they invest in too many assets that are high-risk as their portfolio can lose value at the wrong time. Risk relating to investments can be a minefield.

As aforementioned, political and economic factors also impact the performance of investment marketplace. Political risk includes changes in government, international relations and conflicts and political uncertainty. Whereas economic factors include growth, employment, inflation, interest rates and business sentiment. All of these elements can affect a client’s portfolio.

At the same time, different asset classes come with their own risks. For example, there are risks attached to fixed income such as default risk, where the issuer of a bond does not pay the client back. There is also interest risk. In this instance a client would buy a bond with a 2% coupon and then the next day, the bond is issued for 3% (of the same quality). The price of the already purchased bond will fall in order to match that of the 3% bond. Equities are considered to be high risk due to the fact there is zero guarantee of a return. A % ownership of a company can either offer considerable upsides and be a key component of growth of a portfolio, or the returns can be dismal. Gold on the other hand tends to be a protection asset, due to the fact it is not subject to inflation.

As consequence, it is intrinsic that an advisor can explain the relationship between risk and rewards of investment strategies, so clients are able to understand how their portfolio is structured through time. Understanding risk and a client’s attitude to risk is imperative to portfolio creation and the selection of assets that are managed.

There is no hard and fast rule on risk. Linear has seen many companies try to make it more of a scientific experience for investors with risk tools, scores, algorithmic and psychometric approaches.  The reality is that the industry has an extremely tough task to map a clients attitude to risk and risk score into a suitable portfolio and not just on an initial basis but do this on an on-going basis. Portfolio drift can often lead to a client starting out in a cautious portfolio but throughout the year end up drifting into a balanced portfolio without having made that decision themselves.

Keeping that alignment is absolutely critical. This means a good attitude to risk process from outset by the advisor, well mapped portfolios, structured rebalancing process, good portfolio descriptions

And above all else a good communication process between all parties. Linear’s Managed Portfolios provide a structured solution for financial advisors. We understand the challenges of our introducing advisors and our service standards reflects this.

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