Quantum of Tolerance Paul Roberts proberts@arlingclose.com

Regular readers will know that The Return is Not Enough when assessing the performance of longer-term investments and that risk has an essential role to play, with risk tolerance a key part of this. Assessing risk tolerance is no easy task and requires a variety of both objective and subjective judgements. A realistic and unbiased assessment is tricky enough at the level of the individual, but when a number of individuals are trying to determine an organisation’s risk tolerance this can open a whole can of worms as differing views, opinions, and emotions bash against each other.

All investments carry some form of risk, be it credit exposure to an organisation going bust, market risk from the price volatility of a particular asset class, or the liquidity risk of not getting your money back when you need it. There are also others, including shortfall risk which is that the investment portfolio will not generate the level of return needed, something which can occur when the level of risk taken is too low to achieve the required investment objectives.

Many investors, particularly those dealing with taxpayers money such as our clients, would probably consider themselves low risk (despite some investments suggesting otherwise), but with reductions to budgets and cuts to services, can some investors afford not to take more risk?

Now, we are not certainly suggesting a risk-taking approach to investing, far from it, but more a managed approach where an ‘appropriate’ level of risk is taken to achieve the aims of the investor and thought given to how much of a return is needed.

Some investors may be willing to accept the risk of bigger losses in exchange for larger gains, but to take the risk of accepting potentially bigger losses may open one up to being asked some very awkward questions by stakeholders if the worse happens, leaving one shaken, or at the very least stirred. Taking too little risk is unlikely to lead to a similar line of tough questions, but in some ways it should, because if the investment is not being put to work properly, then questions should be asked, particularly if the investment is needed to fund expenditure in the future.

For income-focused clients, one place to start for a required return could be the amount (in £ terms) of income that is desired (or in some cases, needed). This number divided by the total investment balance will give the required return the portfolio must generate to achieve that objective. Using this number, one thing to immediately assess would be how realistic this figure is in relation to capital market expectations for asset class returns (cash, bonds, equity, property etc). If the answer is, say, 3%, then great, but if a 15% return is needed then perhaps some serious questions need to be asked before moving forward.

Once the required return has been established then the level of risk needed to achieve that return can be assessed. Perhaps the most often used measure of risk is standard deviation, which is based on the variability of returns around their mean value. All funds will provide information on their volatility over various timeframes. For maximum prudence, investors could assess the standard deviation of a single fund (or asset class) in isolation to determine if they would be willing to accept the degree of volatility that the historical performance shows, particularly if it has exhibited periods of negative returns, and therefore a potential erosion of capital, at least on paper. But for a more realistic and complete picture, the volatility of individual funds should be assessed in the context of a portfolio, as this will include the important correlation of one fund with the others and therefore the degree of diversification that can be achieved by mixing funds.

Assessing risk tolerance must include an investor’s willingness and ability to take risk. The ability to bear risk is more straightforward and looks at the investment horizon, expected level of income, and general level of reserves available to absorb losses. Typically, a longer horizon and higher level of reserves suggests a higher ability to take risk. However, an investor’s willingness to take risk is a psychological and subjective assessment with no single agreed-upon method for measuring it. Moreover, cognitive and emotional biases can muddy the waters even further as the investor’s beliefs and actions may be inconsistent (i.e. the investor classifies themselves as very low risk but invest in equity funds). To add more difficulty to the process, there is often a conflict between willingness and ability, particularly if a willingness to take risk is not backed up by an ability to do so.

Investment constraints that also need to be factored in include time horizon, liquidity requirements, taxes (if applicable), legal and accounting issues, and any other issues such as Environmental, Social and Governance (ESG). Time horizon and liquidity are instrumental in determining the investor’s ability to take risk. A short time horizon and a high need for liquidity means taking less risk while the opposite means more risk can be taken as the longer time horizon helps any short-term volatility to be smoothed out.

Determining these constraints may be straightforward for many investors and be incorporated into the investment decision easily, but some, particularly if they include a preference for ESG investing, or the even more restrictive ethical or positive impact investing, can have a significant influence on the potential investment universe and the outcomes that can be achieved.

Then, armed with this information, the task of deciding on a suitable asset or fund allocation can begin.

To be continued …