The Magic of the Markets: considering Risk, Capacity for Loss and Term.

This edition's article is an attempt to expose the academic and practical underpinning to what we believe is the most rigorous and reliable risk model available to advisers. Synaptic does not mediate between the model and the adviser as other systems do.

While clients seem to be taking advantage of greater financial flexibility, it appears that they do this with some reservations.

The projections are applied uniformly to all investments, thereby providing a consistent measure for risk, presented as a VAR or 'Value at Risk' measure. This is the format most relevant to the requirements of MiFID, and more useful than being presented with analysis of historic volatility, or a 'qualitative overlay', which will be an expert's opinion, clouding any objectivity that should reside with the adviser.

Compound Interest is often referred to apocryphally as 'the eighth wonder of the world' – and has been variously attributed to Albert Einstein / Benjamin Franklin or John Maynard Keynes. But it would go unnoticed in an investment context if the markets didn't perform their own miracle, that of transforming a 'random walk' into an inexorable trend of growth. This is what happens when the millions of individual components that make up the economy pull in the same direction vis a vis the prospects of companies and markets, overall, to create growth. Aligning to markets is what customers seeking investment returns come to financial advisers for, and this is the great benefit they bestow. It's what differentiates speculation from investment.

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 outlines some research to demonstrate the efficacy of the markets, in particular the role of 'term' in investment – effectively the 'managing out of risk' over time. It then offers an insight on how the Synaptic model frames risk-based decisions in an investment context, presenting finally, an example of how the Synaptic risk metrics can be used to create a matrix for the identification of an appropriate asset allocation in the advice context.

Consideration of term

Term changes everything. The higher the Capacity for Loss, the higher the investment risk an investor can afford to take. Investment risk 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 overleaf. It 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 implies 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.

How does term reduce risk of loss?

Over short time periods, an index such as a FTSE or S&P can deliver exceptionally high or low returns. If we look at the S&P 500, 1973 – 2016, the worst 1 year rolling return was -43% (to month ending February 2009). The best was +61% return (to month ending June 1983).

However, the worst 20 year rolling return was 6.4% (gain, to May 1979). The best rolling 20-year period delivered an average of 18% a year (to March 2000). So you could argue that if you are definitely going to be invested for 20 years, capacity for loss is irrelevant. The trouble is, that is not how compliance works!

Rolling Stock Market returns

The beauty of asymmetric investment returns over time

 Rolling Stock Market returns

Rolling Stock Market returns / S&P 500 historic data

The beauty of the asymmetric investment risk and return over time

Rolling Stock Market returns / S&P 500 historic data

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.

The A2R ATRQ has proven itself over many years and is widely used owing to its role as the designated questionnaire accompanying Moody's risk model.

Academic research has interrogated the questionnaire's population sample to provide scoring alignment with appropriate risk categories, which can then be mapped to suitable investments.

Table showing equity portion in the asset allocation for each risk category. Contact Synaptic for full Strategic Asset Allocations

Risk Profile Asset split type Equity portion *Asset allocation (10 year term analysis)
Very Cautious Strategic 8 1
Cautious Strategic 15 2
Moderately Cautious (Low End) Strategic 40 3
Moderately Cautious (High End) Strategic 46 4
Balanced (Low End) Strategic 56 5
Balanced (High End) Strategic 65 6
Moderately Adventurous (Low End) Strategic 76 7
Moderately Adventurous (High End) Strategic 82 8
Adventurous Strategic 94 9
Very Adventurous Strategic 100 10

Example of an investment strategy employed by a Synaptic customer, using Synaptic and Moody's research.

*Adjustment of asset allocation according to term

Risk Profile of customer 5 Year 10 years 15 years 20 years
Very Cautious 1 2 3
Cautious 2 3 4
Moderately Cautious (low end) 1 3 4 5
Moderately Cautious (high end) 2 4 5 6
Balanced (Low End) 3 5 6 7
Balanced (high end 4 6 7 8
Moderately Adventurous (low end) 5 7 8 9
Moderately Adventurous (high end) 6 8 9 10
Adventurous 7 9 10 10
Very Adventurous 8 10 10 10

A reminder of what MiFID is about when it comes to risk

MiFID II introduces a new requirement for firms to provide retail clients, receiving an advisory service, with a suitability report specifying how the advice given meets the client's circumstances. Important points to reflect on:

  • Responsibility to undertake the suitability assessment lies solely with the firm;
  • Where products are packaged or bundled, there is an obligation to ensure the overall package or bundle is suitable. Research tools like Synaptic that track funds by share class according to availability by product are essential for accurate illustrations;
  • Confirming that the suitability assessment relates to buying investments, but also to hold or sell recommendations;
  • Requiring firms to adopt policies and procedures to ensure that they understand the nature, features (including costs and risks) of instruments selected for clients;
  • Advisers must begin disclosing actual costs and charges associated with client investments, rather than estimates, as well as comparing growth projections with actual performance. Accurate growth forecasts from a stochastic model such as Moody's suddenly becomes much more valuable;
  • Risk tolerance is the measure of how much investment risk the client is willing and able to take;
  • Attitude to risk is the client's psychological willingness to take risk, measured by the scoring from the psychometric questionnaire;
  • Capacity for Loss is the client's financial ability to bear risk and cope with adverse outcomes. It relates to investment horizon, and the level of income, assets and liabilities. FCA policy also describes Capacity for Loss as the amount that a client can 'afford to lose before having a material impact on [their] standard of living';
  • The expert assessment of the adviser (through fact finding, knowledge of the client's circumstances and, increasingly, use of cash-flow models), provides the Capacity for Loss calculation. This is the lynch-pin of advice and compliance;
  • Need to take risk is measured by the advisers themselves by evaluating clients' investment goals, time horizon and the financial resources at their disposals;
  • Reconciling attitude to risk, capacity for loss and the need to take risk is a key role of the adviser, and an area where substantial value can be added.

Below. Synaptic software includes the A2R Risk Questionnaire, the most widely used ATRQ in UK. To be used in conjunction with the Capacity for Loss Questionnaire, also below.

 Synaptic Software - A2R Risk Questionnaire

Capacity for Loss Statement