Risk and value

Risk and value

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We have seen several people recently who arrived with an existing portfolio on which they have been taking advice for several years. This is not uncommon, given that people with existing investments have either been managing it themselves or they have engaged a professional to help them.

A professional adviser is required to obtain various relevant qualifications to be allowed to practice and to maintain their knowledge by undertaking a mandatory amount of annual continuing professional education. One might reasonably expect, therefore, that that this would improve the chances of a positive outcome compared to investors who embark on their journey without such guidance.

Despite this, we have seen some surprising results of this advice.

Caroline has a well-paid role in a multinational and intends to retire in the next couple of years. She has accumulated an investment portfolio of around £1m. When we originally met with her, we learned that she had this portfolio managed by a well-known money manager. A study of the the periodic statements that she had been issued revealed some interesting facts about it. But first, it may be helpful to outline how a financial planner considers investment risk.

As part of our standard process when working with a client, we seek to ascertain what we call their risk profile. This comprises three elements.

  1. The first is their risk tolerance – this is a measure of the extent to which they are comfortable with the idea of taking investment risk. There is a body of academic research on this, which finds that generally our risk tolerance is something which has been determined by the time we reach our early twenties. It then varies remarkably little, although there is a gradual decline with advancing age.
  2. The second is their risk need – how much risk they need to take in order to achieve their goals, given their existing assets and liabilities and various assumptions about the future. These assumptions, which vary between individuals, encompass such variables as their expected earnings, expected expenditure, future inflation and investment returns and how these might change over time. Establishing their need to take risk is therefore essentially a numerical exercise. as by feeding all this data into software which projects their cashflow over their lifetime, it is possible to determine the investment return that would be needed to meet their goals in the required timescales. Working back from the assumptions made about future investment returns and costs enables us to establish the implied exposure to growth assets such as shares.
  3. Finally we consider their capacity to accept risk. This is based on the extent to which their future expenditure depends on their invested capital. If they have other sources of income or capital or if they could spend less without hardship, then their capacity is higher than if they rely on their investments for everything.

Unsurprisingly, there is rarely consistency between these three elements. Part of the benefit which should come from working with an adviser is that they have the framework, the tools and the experience to carry out this exercise in an objective and consistent way that provides some insight into the sort of strategy that a client will be able to follow through. Like a three-legged bar stool, if any one of the components is missing, the strategy will fall over sooner or later. If the tolerance is not established, however sound the approach there is a very good chance that the investor will bale out simply because they cannot live with the associated risk. If the need is ignored, then there is a good chance of being invested in such a way as to make the achievement of their goals more difficult. If the capacity to withstand risk is disregarded, an unexpected event which results in returns being lower than planned can throw the plan off course to the extent that recovery is difficult or impossible.

When faced with such inconsistencies, the planner then works with the client to determine a compromise solution which accommodates the differing results and takes account of each of them to create something which will optimise the chances of them meeting their goals.

When we meet with a new client who already has an adviser, we therefore expect that they should have a head start in that they should already have gone through this exercise. After all, regardless of the fact that it is a sensible approach for anyone trying to help their clients to achieve their objectives, for the last eight years it has been a requirement of the UK financial services regulator, now the Financial Conduct Authority, that advisers carry out this exercise before giving advice. Indeed, since circumstances change over time, it is necessary that it be reviewed at regular intervals, at least every few years, to ensure that the investment strategy being pursued remains appropriate.

After discussion, Caroline and we agreed that investing around 30% of her portfolio in growth assets would be appropriate.

We were therefore interested to see that, despite having worked with her current adviser for several years, Caroline’s existing portfolio was invested entirely in such growth assets. Yes, 100%. Nothing to dampen the inevitable fluctuations in value that come from investing in the stockmarket, or to protect against the damage that making withdrawals from the portfolio at a time when its value could be depressed (as is almost certain to the case at some point) could cause.

To add insult to injury, the costs that she is paying for what is basically pure portfolio management rather than financial planning based on her goals are actually higher than the total costs that she will pay for us to work with her. Those costs include our fees, the costs of the underlying investments and those of the accounts in which the portfolio is held.

Financial planners frequently hear arguments that advice is too expensive and that it is poor value for money. Value is something that only the client can assess and sometimes it is only apparent when being able to compare it with something else. In this case, Caroline did not find it difficult to identify who was providing her with value for money. And, just as importantly, who wasn’t.