Risk tolerance is a key part of the wealth management process. Risk is hard to quantify as it is a subjective measure. Ultimately, the level of risk you are prepared to take often comes down to whether you can sleep at night without worrying about whether your portfolio is losing money.
Your adviser can use a number of different methods to assess your risk tolerance and help you to express your own view of risk. These can include personality tests and, more typically, asking a series of questions. Among the more straightforward questions that may be asked are: what level of income do you need from your investment portfolio over the next five years; and how much capital are you prepared to lose during any 12-month period?
This will provide a guide to how much investment risk you are prepared to take. For instance, if you are unprepared to lose more than five to 10 percent of your original capital over the next year, this will normally limit your exposure to equity markets. This provides a quantitative assessment of risk, rather than simply describing your portfolio as low, medium or high risk. Questions about how much capital you are prepared to lose should also cover different time periods, such as one, five and 10 years for example.
A more sophisticated approach
There is more sophisticated questioning, however, that a wealth manager can undertake, to establish a more accurate risk profile. The wealth manager may ask you to rank statements in the order of greatest concern to you. Here are four statements as an example, where you would be asked to say which one would worry you the most and rank the others in order.
The wealth manager can drill down even further to try to ascertain your risk profile. One method is to give you projected portfolio returns that provide an average expected return per year, alongside the range of returns this portfolio may produce every 12 months and the worst possible case scenario with this portfolio.
For example, a portfolio with an expected average annualised return of 6.5 percent may produce a range of returns of -2 percent up to 13 percent every year with the possibility of producing a worst case scenario of -4 percent. In comparison, a portfolio with an expected annualised average return of nine percent may produce an annualised range from -7 percent up to 24 percent, with a worst case scenario of -20 percent. The range of returns possible is a reflection of the greater risk you are taking to produce a higher expected annual return.
The purpose of this exercise is to try to verify that, for a nine percent average annualised return, you are prepared to accept a potential loss of 20 percent in any one year. You should be aware of the risks you are taking with your investments. These include not only losses against the stock market, but also the real value of your assets if they do not increase in value as quickly as the rate of inflation. If your assets do not grow and inflation is at a rate of 2.5 percent, your investments will decline in real terms by more than 25 percent over 10 years, when the compound effect is calculated.
Questions you may be asked
The degree of sophistication used during the question and answer session on risk tolerance will vary from one wealth manager to another. Here is a list of questions that a wealth manager may ask you before constructing an investment portfolio. This provides a guide to how comprehensive this part of the wealth management process can be.
1) What is the value of your investment portfolio? What percentage of your total assets does this represent?
2) Will you need income during the next five years from this portfolio? If yes, when will you need income and how much?
3) Will significant cash withdrawals be made over the next five years? When are these withdrawals likely to be made and how much are they likely to be?
4) For how long will the portfolio be invested? Will it be less than five years, between five and 10 years or more than 10 years?
5) How much of the portfolio can be put in assets that require a minimum investment period of five years?
6) What average annual return do you hope to achieve from the portfolio? What annual average real rate of return do you hope to achieve?
7) Which of the following are the most important considerations to you? Rank them in order of importance:
8) Are there any asset classes you do not feel comfortable investing in? The list will include, amongst others:
9) If your investment portfolio enables you to achieve your long-term objectives over the time period agreed, then over what length of time are you prepared to accept a substantial loss in capital:
10) As a follow on question to number 9, you may be asked whether you are prepared to alter your objectives, increase your amount of savings, or the length of time you will have to save, if you are only comfortable with market volatility of less than two years.
The questionnaire should not be an end in itself in assessing your risk tolerance. It is to be used to spark a discussion, not only about risk, but also about what you can expect to achieve from the wealth management process.
Having ascertained your risk tolerance, your adviser can draw up an asset allocation and select stocks and funds within your portfolio. The importance of diversification in an investment portfolio, the differences between asset classes and how to construct a portfolio is dealt with in later chapters.
Remember that wealth management is about more than investments, retirement and tax planning. Wealth management should cover all your financial affairs and help you to achieve all your financial objectives. This cannot be achieved just by buying a portfolio of investment funds. There are other issues, such as pensions, inheritance tax, banking and planning for school fees, amongst others.
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