Considering Risk, Capacity for Loss and Term

28 May 2019

Eric Armstrong of Synaptic looks at some of the ways Financial Planners can assess and work with investment risk

It is very difficult to predict the outcome of an investment in the short term, but medium term we can predict much more accurately. It is a similar explanation as to why a dice may have 1 out of 6 outcomes in a throw, meaning the next throw is impossible to predict. However, throw a dice 10k times and the outcome can be predicted with certainty. 

This article looks at the role of term in investment – effectively the ‘managing out of risk’ over time. It offers an example of how the Synaptic risk metrics can be used to create a matrix for the identification of an appropriate asset allocations in the advice context.

Consideration of term

Term changes everything, including Capacity for Loss calculations. The higher the Capacity for Loss, the higher the investment risk an investor can afford to take. Investment risk (loss) diminishes as the term extends, as ‘Sequence of Return Risk’ is mitigated.

Why do Product Providers recommend portfolios with high equity content to ‘Cautious’ investors? When a fair assumption can be made regarding the long term commitment to the term by the client, often the case in pensions recommendations, this can be deemed suitable.

Establishing the client’s long-term commitment to their investment term, in conjunction with the A2R Questionnaire, will qualify the role of term in reducing Capacity for Loss.  See the matrix below. The additional question asset we use is not scored in the way an ATRQ is, as the there is greater reliance on the judgement of the adviser. This secondary questionnaire therefore offers structure to the discussion, and provides a format for recording the advisers final recommendation on risk.

A2R: Customers have a lower capacity for loss when some or all of the following apply:

  • They have no way to replenish their capital (for example, no longer earning);
  • They rely on the investment for income in order to meet expenditure;
  • They have a short investment horizon (losses are unlikely to be recouped prior to crystallisation);
  • They are exposing a large part of their available assets to the risk of a fall.

The Ombudsman doesn’t adjudicate on the ability of any sector, strategy or index to achieve profitability in the long term, despite often doing so. They adjudicate on the experience of loss in the short term (hence need for Capacity for Loss analysis). It may be appropriate to take on risk for the long term, but the risks need to be clearly explained and understood.

Example of an investment strategy employed by a Synaptic customer, using Synaptic and Moody’s research. Asset allocations are defined using Moody’s efficient frontier.

This article was orginally published by Financial Planning Today