In this edition of Technical Update Michael Holland, one of the founders of data provider FE, looks at the thorny issue of assessing client appetite for investment risk.

Michael looks at the various methods used and challenges existing assumptions about what risk assessment should look like. He believes that ultimately there has to be more than just a technical approach and the human element is essential in assessing a client's true appetite for risk.

He believes current approaches are too basic and in future will be frowned on but planers are well placed to move forward with their risk assessment strategies as the regulator demands a more robust and transparent approach when it comes to assessing risk.

This thought-provoking polemic provides plenty to think about for those assessing or reassessing their own client risk profiling approach with clients.

To suggest ideas for Technical Update email editor Kevin O'Donnell at This email address is being protected from spambots. You need JavaScript enabled to view it.

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The financial services industry has had its share of scandal over the past few years and the new regulator is quite rightly sparing no effort to caulk the leaking ship.
One thing that has caused a lot of regulatory concern is clients investing in products they don't need or understand.
A key area of concern is their understanding of the risks in their investments, and it is here that Financial Planners and advisers need to devote a large part of their efforts to do a conscientious job and keep their clients happy. The problem is that the way that some advisers and investors look at risk can be quite basic.
Some people new to the profession already express disbelief that advisers used to be given commission for recommending certain funds, and it's quite possible that we will look back with the same incredulity on the industry's primitive glossing over of the notion of risk. The standard way of looking at risk in the industry is through volatility, which simply measures the standard deviation of a fund or portfolio's returns.

In other words, it looks at the square root of the product of the squared differences between each observed value – daily, weekly or monthly returns – and the mean.
The reason for squaring the differences is to remove the effect of the signs and treat positive and negative numbers alike, which is neat and tidy for mathematicians but bonkers as far as the man in the street is concerned. Building on this, the Sharpe ratio uses the standard deviation as the denominator and the differences between the returns on a portfolio and a risk-free rate as the numerator. This gives "risk-adjusted" returns, measuring, in theory, what returns an investment provides per notional unit of risk taken on.


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A higher Sharpe ratio should, in theory, tell an investor that this portfolio is better than one with a lower ratio, because the performance achieved divided by the risk taken is a higher number. For example, if the volatility was 3% and the excess return was 9%, then the Sharpe ratio would be 3 and you would probably be a happy investor. However popular this way of looking at risk this might be, it is very far from how investors view risk, and herein lies the danger in my view.

Volatility measures dispersion of returns, without taking into account their direction. In reality, investors tend to be far more worried about loss. To the average person-in-the-street, the idea that a fund making money is displaying "risky" behaviour is absurd. Using volatility as the be-all and end-all, a fund which was to make many rapid share price gains could receive a high volatility score and be classed as risky while a fund which provided steady returns of 1 per cent per annum would be classed as very low risk, yet slowly and steadily destroy investors' capital through the effects of inflation.

There are plenty of examples of funds in the IMA Targeted Absolute return sector that have low volatility scores but have steadily been losing investors' money over the years, either in real or absolute terms, some of them, mercifully, closed. Consider this fund, name blanked out and marked B on the graph below, which is top-quartile for volatility over the past three years but has lost an average of 0.08 per cent a year over that time.
Professionals may find a home for a fund that behaves like this, but the average man in the street would be outraged if you told him that this fund was designed to protect his capital.

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Investors' idea of risk is built around fear of loss, and it is this that I believe planners need to build into their models. Many basic risk profiling models rely heavily on volatility, but as this doesn't match up with investor expectations it is a recipe for unhappy clients or worse. One superior measure in this respect is the downside risk. This simply measures the downside volatility of moves in an investment's value. When an investment falls in price, difference from the risk free rate is recorded and the same steps are gone through to calculate the standard deviation.

The analogous measure to the Sharpe ratio is the Sortino ratio, which simply measures returns over a risk-free benchmark divided by downside risk. Downside risk gives a better measure of the sort of performance that is likely to trouble investors – an investment's loss of value. Some investments can be much less volatile on the downside than on the upside, a great combination for an investor.
The Hermes UK Small and Mid Cap fund, for example, had a downside risk over the three years to the start of this one of 9.86 per cent compared to a volatility score of 12.77 per cent. On its FTSE 250 benchmark the scores were 18.58 per cent and 16.93 per cent respectively, showing what a good job the managers did of limiting the downside volatility of their market in that period.

Sortino better ranks investments in terms of how they eke out returns without exposing investors to temporary paper losses. Ultimately this is more useful to advisers, because most investors are far more concerned by losses than gains.


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Another way of bringing capacity for loss into the assessment of investments is through Roy's safety-first ratio, which is easily applied to client-specific situations.
The measure has an identical structure to that of the Sharpe ratio, but with different inputs. First the investor needs to decide the minimum gain acceptable, which could also be zero. Then the calculation is simply the expected return on the investment minus the threshold level, divided by the standard deviation. The higher the number produced, the better.
The higher the safety-first ratio the higher the probability that the returns are over the threshold and the lower the chances the return on the investment are below it. Using this measure we can compare investments with very different risk/ return profiles. For example, an investment with an expected return of 10 and a volatility of 5, when the minimum acceptable gain is also 5 has a ratio of 1. An investment with an expected return of 16, volatility of 10 and the same threshold that must be reached has a ratio of 1.1. Of course, all this is predicated on an original modelling of an expected return.
Another measure it is useful to look at, and much simpler, is maximum drawdown, and this can be quite a useful way to compare funds for clients. Maximum drawdown simply looks at the worst possible result for an investor in a fund over a certain period of time: their, usually negative, return if they had bought and sold at exactly the worst time. It's more concrete than abstract figures of volatility or downside risk, which it can be hard for laymen to grasp.

It could be a useful exercise to show investors what an investment has done in times of great stress – the financial crisis of 2007 and 2008 is recent enough to serve as a decent example – and simply ask them to imagine what they would feel having seen their investment fall by that amount. Could they stand it? Would that be acceptable to them? This relatively un-technical way of looking at things is likely to be more fruitful in terms of building trust with a planner or adviser rather than a long-winded explanation of volatility.


And the insight is the same as that behind the RDR requirement for investors to be given charging information in concrete examples of pounds and pence that are easy for anyone to grasp. Ultimately, it is this sort of exercise that is likely to prove crucial in forging a good client relationship. Nothing can fully substitute for the human element, however. For planners to incorporate a client's capacity for loss into their process it won't be enough to simply come up with a superior calculation for risk. The task is to uncover a client's attitude to loss – which he likely won't be aware of himself – and make his investment options comprehensible in the light of it.
Another issue which a simple volatility measure hides is the interaction of investment style and economic climate: investments can vary hugely in their performance in different market conditions. Investors who built their expectations for a fund's performance on its volatility in the run up to the 2007 and 2008 market crisis would have been, and were, shocked by the huge losses they incurred. Similarly, there are many defensive funds which were looking very good in relation to the markets over five years until the markets started to rise sharply in 2012, and their relatively good performance in 2008 fell off their five-year performance figures.


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Suddenly, many funds which appeared to be "safe", and to have a great combination of low risk and high return have now been put in a more realistic light: they do very well in certain circumstances but not so well in others. A lot of investors are changing their opinion of funds they had held in high regard, and in many cases perhaps unfairly. Communicating why and when investments are likely to underperform is vital if clients are to retain faith and trust in their advisers and planners and make sensible long-term decisions rather than move into and out of the flavour-of-the-month investment.
This is where planners have to go beyond maths, and where the softer skills of building relationships and empathising with clients comes in, I believe. There are more sophisticated ways to measure and think about risk mathematically, but taking into consideration only this dimension of the problem is unlikely to lead to happy clients. While investors cannot be expected to understand everything that a planner does for them and every aspect of their calculations, ensuring that clients are involved in the fashioning of their portfolio's risk profile is vital. With much of the industry moving into risk-targeted funds it is crucial that we go beyond simple volatility as a measure of that risk and don't expect our simple categorisations to save us if investors become upset.
If mis-selling scandals are often at heart about a lack of client understanding, deficiencies in analysis and explanations to clients are likely to be equally frowned-upon in any future crisis, even if they are acceptable now.