Attitude to investment risk is only part of the picture as investors face many uncertainties that are in reality more meaningful to them as they are often the reason for investing. These can include the following:
• Not achieving an adequate income in retirement, perhaps due to poor long-term performance of investments compared to inflation,
• Failure to meet a specific investment objective. For example, repaying a mortgage.
• Capital depletion by drawing a level of income which cannot be supported by an investor’s capital.
Most of the major advice problems that have hit the headlines and involved compensation claims have arisen from failures to meet investors’ investment objectives. These include the following:
• Mortgage endowments – failure to pay off mortgages.
• Pension transfers – giving up guarantees which damaged retirement income.
• Capital erosion – drawing an income not supportable by capital.
• Short-term capital loss – failure to understand investment term objectives.
While an investor’s attitude to investment risk is a relevant factor, it is outcomes that trigger investors’ complaints and the failure to meet their expectations. The risk profile from a questionnaire does not have a tangible reality to an investor. What does being a ‘balanced’ investor really mean? Showing a benchmark asset allocation does not do it. It is only when the investor sees the likely outcomes from a chosen risk profile on an investment objective that there is full engagement.
The industry’s failure to engage effectively with investors has been the root cause of unhappiness for some investors. Communication at the outset of potential outcomes is an absolutely critical part of the advice process, and the communications must enable investors to understand the impact of these outcomes on their objectives.
As part of this process of engagement, it is vital to consider the investor’s capacity for loss. Capacity for risk is preferable as it takes full account of the impact of investment loss but also recognises that some investors might benefit from taking more investment risk, particularly in the early years of saving for retirement. While additional questions need to be asked to establish capacity for risk, this process is difficult to codify since it involves an assessment of an investor’s personal circumstances and how different investment outcomes might impact on those circumstances. The output from this step might be an adjustment to the investor’s risk profile (usually, but not invariably, downwards to a lower risk profile). It is essential to engage investors by creating credible future scenarios for them to consider.
Stochastic modelling offers a unique way of ensuring that investors are fully engaged and can ensure consistency between an investor’s risk tolerance and the recommended investment solutions. Stochastic forecasts of outcomes enable investors to understand the trade-offs that are part of achieving investment objectives.
