In matching a client's capacity for loss, advisers should target likely risk instead of looking at historical performance. John Ventre of Old Mutual Global Investors explains.
There is one thing all risk profiling approaches have in common: assessing a customer’s capacity for loss.
This is critical to sound financial advice because there is an enormous amount of evidence suggesting that, when capacity for loss is exceeded, investors make obvious investment mistakes, such as selling out at the bottom and buying back in once the market has gone up again.
There are many ways of assessing capacity for loss. One way is to ask the question directly with a so-called psychometric assessment designed to understand what type of personality an investor has in an attempt to ‘predict’ future reaction to potential losses.
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Such a risk profiling approach is the beginning – not the end – of good financial advice. Discussion with the client of the consequences of the outcome, in order to identify whether the questionnaire has done its job, is critical.
Does it fit?
Having assessed capacity for loss, the remaining question is whether the client’s investment portfolio matches it. In fact, this is where things get much more difficult.
The key challenge is that we need to analyse future potential losses, not merely historical performance. By the time December 1999 rolled around, most investors had forgotten what it felt like to lose money in equities, such was the length of the bull run.
Equally, fund track records had not exhibited significant drawdowns so many unsuitable investments would look “suitable” based on an historical analysis.
This is, of course, the weakness we are all aware of in past performance analysis.
A better approach is to analyse what assets a fund holds, or is likely to hold, as a means of assessing what future drawdowns might be based on the long term history of asset class behaviour.
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