Framing Risk in a Low-Interest World

The industry view is that interest rates will be lower for longer.

In this environment, what’s the best strategy to balance risk with return for clients who want the best of both worlds?

Analysing Risk Effectively

Most traditional risk analysis methods focus on objective risk factors such as the need for income, and combine this with subjective considerations such as the client’s reaction to potential losses.

These two factors are categorised into risk capacity and risk tolerance respectively. But what are the best methods for analysing them?

Risk capacity is fairly straight forward, being an objective measure indicated by factors including the client’s portfolio and time horizon.

Risk tolerance is more difficult, and questionnaires are usually the go-to method. The consideration here is to avoid questions that prime clients for a certain response. Asking abstract questions such as “how would you feel if your investments reduced by 10%” are more effective than direct questioning.

But questionnaires shouldn’t be relied on entirely. There are many great analysis tools out there which can enhance your risk findings, such as Riskalyze, FinaMetrica, Tolerisk, and PocketRisk.

Each carry their own merits - but avoid the traditional method of combining their risk capacity and risk tolerance scores.

If your client has high risk tolerance but low risk capacity, merging these scores won’t come to the ‘true’ answer. In reality, the actual capacity for risk is more important than the client’s feeling towards it.

Similarly, if your client has strong return goals and high risk capacity, it can be an error to shackle this by adding in low risk tolerance as an equal consideration.

Applying a Focused Strategy

By not combining risk capacity and risk tolerance, you’re free to implement more focused strategies to address each one.

If your client wants higher returns than they have the capacity to handle, you can outline worst case scenarios and ask what they’d do in these conditions. Once these situations have been visualised, ask how much of a reduction in returns would be acceptable to avoid them.

If they have high risk capacity and want high returns, but are instinctively put off by risk, then you can implement strategies to increase their risk tolerance.

Risk tolerance is usually based on emotions and bias, rather than solid rationale. An Unbiased poll showed that 71% of clients view P2P loans as higher risk than equities - presumably as the newer product is less familiar and therefore perceived as less safe.

But getting past these emotions can be difficult, so educate clients with clear, concrete examples rather than abstract reasoning. Show them how a drop in value can be corrected, and how clients in similar positions have done well by taking on more risk. Not all clients will be able to grasp the mathematical concepts of risk, but all can understand real life events.

Make it clear that you’re not creating the maximum possible returns just because the client is capable of earning them. Often clients think they’re being safe by being bearish. But choosing to unnecessarily limit the money available for their retirement can be the riskiest decision of all.

This way, you’ll be able to adapt your clients’ understanding of risk to earn them the returns that are right for them.