With a little help from a decades-old theory, Caspar Rock, CIO at Architas, assesses the very real differences between client risk appetite and capacity for loss
Now that the Retail Distribution Review (RDR) has arrived, one of the key areas of impact is client suitability.
The RDR requires advisers to perform more stringent suitability checks, chiefly consideration of how much risk a client is “willing and able to take”.
It therefore seemed an apt time to remember what the FSA says about an investor’s 'capacity for loss' and attempt to address a common misconception that capacity for loss is little different to 'risk appetite'.
Any investment is subject to fluctuations in value: the magnitude of these fluctuations depends largely on - and to a certain extent can by controlled by - the contents of the portfolio.
Cognisant of this, the FSA has had clear guidance in place for some time regarding investment advice. Many advisers have addressed this requirement by devising a fact-find to establish their client’s investment profile.
Unfortunately, the FSA’s reference to “how much risk a client is willing and able to take” has led to the conflation in many cases of two distinct considerations, namely ‘willing’ and ‘able’.
Broadly speaking, the amount of risk an investor is willing to take can be seen as their risk appetite; the amount of risk an investor is able to take, on the other hand, is more akin to their capacity for loss.
The distinction between risk appetite and capacity for loss becomes clear if we consider an investor who is prepared to accept a large amount of risk in order to receive potentially greater returns: in other words, they have a high risk appetite.
However, if it transpires that their investment is intended to fund an imminent retirement, their ability to accept loss – their capacity for loss – is going to be low.
According to ‘bird in the hand’ theory, investors tend to prefer to collect certain returns than risk loss in exchange for greater gains.
Faced with a choice of receiving £450 or flipping a coin, the outcome of which is receiving £1,000 or nothing, only 8% of Britons would flip a coin: they would rather receive the guaranteed prize than risk receiving nothing.
The other way around, however, when the choice is either giving £450 or flipping a coin to give £1,000 instead or nothing, 25% of Britons would chose to flip a coin: they would rather not lose anything, so will gamble the coin flip. In other words, most investors are inherently risk averse.
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