For an adviser it’s not always easy to help your client navigate the risks they face in managing their money. Understanding how these risks support or conflict with your client’s ambitions is a key consideration, but previously there have not been the investment solutions available to support these conversations and tailor to your client’s particular circumstances.

    The three dimensions of risk

    In creating a strong and robust plan for a client we usually consider three dimensions of risk: 

    • the risk they would prefer to take; 
    • the risk they can afford to take; and
    • the risk they need to take.
    1. The risk they would prefer to take is the psychological dimension; how easily will they sleep at night and how will they react if market movements lead to swings in their fund value. There are many attitude-to-risk (ATR) tools that can help an adviser to frame and characterise their client’s inherent risk appetite.
    2. The risk they can afford to take (also known as their capacity for loss) factors in other assets beyond the specific funds that are being considered for investment, e.g. additional reserves of capital or sources of income, such as a DB pension. This requires a balance between taking different levels of risk within each investment and remaining consistent with the client’s overall risk appetite.
    3. The risk they need to take is the translation of the client’s circumstances to the level of risk required to achieve their goals. Often a goal cannot be achieved without a certain level of expected return and this will largely determine the amount of risk that must be taken to have a reasonable likelihood of achieving the goal. What, then, is the right amount of risk to take and which portfolio can best achieve it? This can be answered by modelling the cashflow requirements alongside economic projections that allow for the risk characteristics of the portfolios being considered.

    Managing risk and client expectation

    These three dimensions of risk can often conflict with each other. For example, the ATR score may indicate that the client is naturally quite risk averse, however their goal is challenging and requires a high expected return (and therefore risk) to be attainable. An analysis of their capacity for loss suggests that they could bear at least some of the increased risk, since they have other sources of income which could provide most of their minimum income needs. That being the case, what should they do? Stick with the original goal and invest at a risk level higher than their natural risk preferences, or invest in-line with their natural risk preference and lower their ambitions? Or somewhere in-between?

    There is no single correct answer, and suitability depends on the unique circumstances of an individual client. Being equipped with the right tools and products means an adviser will have the information needed to engage with their client and help them navigate the trade-offs required to craft a sustainable and achievable plan that balances their three dimensions of risk. 

    How IMX technology bridges the risk gap  

    Risk, particularly attitude-to-risk, creates a narrow definition of investment risk that doesn’t take account of the client’s desired outcomes. Simply working through an ATR questionnaire and choosing a fund consistent with the resulting score doesn’t provide a complete picture. Instead we need a more rounded way of assessing risk that converts abstract investment metrics, such as volatility, into the risk of not achieving the outcome. After all, the client is investing to achieve a goal, not satisfy their risk appetite.  

    Using the client’s goal; what is it they want to achieve with their money? We can then work backwards from their desired outcome, testing potential portfolios to understand which offers the best balance between risk and opportunity.

    IMX supports this process in two ways: 

    • The portfolios have been designed with outcomes in mind. Rather than adopt a traditional approach where return is maximised for a given level of volatility, we have taken a large number of realistic hypothetical customer goals and optimised for outcomes-based metrics. These are the likelihood of achieving the goal, the proportion of the goal achieved over the long-term in poor outcomes, and how far off-track the client might be at their next annual review, if returns are below expectation for the year. 
    • The IMX adviser tools provide all the information needed by an adviser to select the most appropriate portfolio for their client. This includes client-specific values for the outcomes-based metrics used to optimise the portfolio allocations - goal likelihood, proportion of goal achieved and one year forward-looking likelihood- plus further details of potential returns over the first year and the spread of fund values in the long-term. 

    By comparing these values for different portfolios, the adviser can have a more nuanced conversation with their client about which one provides the best balance of risks and opportunities for them, using language and figures that describe the situation in terms of the goal they want to achieve. If the trade-off between these dimensions is not acceptable then it also supports a discussion around amending the goal itself: after all, portfolio choice and goal definition are not independent, one impacts the other.

    IMX equips the adviser for in-depth discussions with their client on the two key dimensions of risk not covered by traditional attitude-to-risk analysis. This addresses the risk the client needs to take to achieve their goal, and by looking at outcomes in adverse scenarios, the adviser can compare this to the client’s other sources of income or wealth to see if the proposed plan is consistent with the risk they can afford to take.

    Tools to enable successful risk conversations

    The starting point for any successful financial plan is a realistic goal, and this can be turned into a robust plan by considering the three dimensions of risk. Traditional attitude-to-risk analysis answers the question of how much risk the client would prefer to take but doesn’t offer any insight as to whether their plan is consistent with the risk they can afford to take, or that they need to take. The IMX portfolios and tooling bridge this gap, equipping the adviser with the information needed to have an engaging conversation with their client on risk.   

    David McGruther

    Financial risk modelling consultant, Hymans Robertson

    Risk warning: This communication has been approved and issued by Hymans Robertson LLP (HR) on behalf of Hymans Robertson Investment Services LLP (HRIS) and is based upon their understanding of events as at date of publication. It is designed to be a general summary of topical investments issues, it does not constitute investment advice and is not specific to the circumstances of any particular financial advisory firm. Please note where reference is made to legal matters, HRIS is not qualified to provide legal opinions and you may wish to seek independent legal advice. HRIS accepts no liability for errors or omissions.

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