A Guide to Assessing Your Risk Tolerance

Financial advisers help us shed light on how investors can evaluate their willingness and ability to take on risk

Morningstar.co.uk Editors 3 June, 2011 | 1:14PM

Which of these sayings most appeals to you?
a) A bird in the hand is worth two in the bush
b) Nothing ventured, nothing gained
c) Speculate to accumulate!

This is the type of question a conversation about an investor’s attitude towards risk is likely to start with. It will usually be part of a longer risk assessment questionnaire. An example of such a test, developed by Morningstar’s Adviser Workstation Team, consists of a set of questions that seeks to establish an investor’s time horizon, long-term financial goals and expectations, and short-term risk attitudes. Completing such a test on a regular basis and keeping records of results is a handy way to track how your risk tolerance changes over time.

However, both financial advisers and regulators stress the fact that risk assessment questionnaires are only the first step is establishing an investor’s willingness and ability to take on risk. “A psychometric questionnaire should only ever be a starting point,” says financial planner Martin Bamford of Informed Choice. “It should be followed with a detailed discussion about capacity for loss, the impact of different scenarios both emotionally and on the ability to reach financial goals, and prior experience of investing money,” Bamford explains.

Capacity for Loss
Calculating an investor’s capacity for loss boils down to understanding their current financial standing, future financial goals and how these can be achieved. “In some cases this enables us to identify capacity for loss in absolute terms--in pounds and pence, and in other cases the number is more vague as it will depend on various assumptions and the progress made towards a goal,” says Bamford.

Grasping an investor’s financial circumstances is key for calculating their capacity for loss. Do you have dependants? What are your income and outgoings? What assets and liabilities do you currently have? These are some of the questions which help financial planner Alexandre Riley of BunkerRiley determine his clients’ capacity to take up risk. It goes without saying that a 30-year-old with no liabilities, some savings and a healthy disposable income is likely to be able to stomach considerably more risk than a 65-year-old with limited assets and a pension barely covering their expenses. That said, Riley clarifies that if an elderly investor has a substantial asset pool or a significant income stream and a potential loss will not materially impact their financial wellbeing, then a higher tolerance for risk could be appropriate.

Scenario Rehearsals
One way to ‘stress test’ an investor’s capacity for loss is to develop various scenarios and see how their financial circumstances will change. “The more you rehearse, the less of a shockwave you get if the rehearsal becomes reality,” says financial planner Yvonne Goodwin of Yvonne Goodwin Wealth Management. Goodwin adds that she rarely gets clients panicking over negative market events precisely because of such worst-case-scenario rehearsals.

Three key situations Goodwin analyses with her clients are how their portfolio might change with a sizable wealth drop, the impact of inflation, as well as a change in income after an unexpected event such as redundancy.

How far can your wealth drop before you feel uncomfortable? Try simulating a 20% drop in investment assets by adding a one-off expenditure item that equals a fifth of the value of your current portfolio. This, says Goodwin, can illustrate the effect of a wealth drop and help the individual assess the overall effect on their future cashflow. The reason for showing the fall against invested assets, she explains, is that in most cases invested assets will produce a client’s income over the long run. However, one could also rehearse a fall in property value, she points out.

If suffering a wealth drop makes you feel uncomfortable, how would you feel about moving your entire portfolio into cash? Have in mind that at the moment the rate of inflation is greater than the rate of cash returns, reminds Goodwin.

Finally, how will a change in income impact your finances? In considering this eventuality, Goodwin asks her clients to think about the impact of redundancy, how long they can survive without income and what they would do if the age at which a State pension becomes available was increased.

Financial Knowledge and Experience
Together with understanding an investor’s financial circumstances and personal comfort with taking risk, their level of financial knowledge is also a key principle that Alex Riley relies upon when assessing his clients’ risk appetite. “Many investors misunderstand the word ‘risk’ and that is mainly due to having little investment education and experience,” he says. Riley believes that just because investors might be cautious drivers or adventurous holiday-planners in their day-to-day life, it does not necessarily mean they can, or know how to, translate this attitude towards risk to financial markets. Riley is of the opinion that “too many investors take too little risk because they are mistakenly scared into believing that they could lose all of their money rather than understanding that through knowledge of asset allocation techniques, amongst other things, they could reduce their downside risk.”

Somewhat on the contrary, Martin Bamford finds that his clients “are prepared to take more risk than they need to take in order to achieve a specific goal.”

Goodwin’s client base is perhaps somewhere in the middle. Everyone’s risk appetite is different, she says and points out that investors can become more cautious as they move closer to retirement and worry about seeing their wealth decrease, or more confident when they know they have a trusted adviser helping them steer through the markets.

Reassessing Risk Tolerance
The point that risk preferences can change over time is an important one to end on. We’ve written before how an investor might want to change their asset allocation at different life stages. Financial planners also re-evaluate their client’s risk exposure once a year at a dedicated annual review. Martin Bamford notes that more cautious investors tend to need more regular reviews of their attitude towards investment risk. As ever, we would warn investors—risk averse or risk hungry—to exercise caution and patience when tempted to react to events that impact markets, such as natural disasters or sovereign credit downgrades. After all, the exercise of rehearsing scenarios takes place precisely in order to help investors 'keep their cool' when markets get heated.

Morningstar’s new Asset Allocator tool, part of our Premium service, can help you assess your investment goals and which path to take to achieve them. Of course such tools are just that—tools—and should not be wholly relied on as the basis for investment decisions. A professional financial adviser will be able to assist you in further identifying your risk tolerance and tailoring your asset allocation to your personal investment needs.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar.co.uk Editors  analyse and report on shares, funds, market developments and good investing practice for individual investors and their advisers in the UK.