Demonstrating Tolerance For Loss
JodiePowell
Member
We are currently reviewing our Risk Profile wording and was wondering how people demonstrate a client's Tolerance for Loss.
We use the FE Risk Profile and while this is helpful in demonstrating Capacity for Loss, there is not really any assessment of Tolerance for Loss.
We currently have wording along the lines of:
You have confirmed you can tolerate losing X%, based on your portfolio value of £X , this would mean a loss of £X.
This information derives from the Adviser's discussion with the client.
Would like to know if there are any other methods/process that could help.
Comments
Talk to the client about their previous investment experiences. How did they feel when things went bad? What did they do? How much did they see their investments fall by?
Sleep at night test - what level of loss would cause you to lose sleep?
As an aside, there isn't (in my view) a risk profiling tool on the planet which can asses a client's capacity for loss.
Capacity for loss is relatively easily calculated in a cash flow tool - it's a number.
Tolerance is an attitude, feeling, behaviour etc and there isn't a tool to calculate that. It needs to be a discussion with the client.. I like @richardgough "sleep at night" idea. One adviser I work with asks clients "how much would you be comfortable losing before you want to punch me in the face?". Clients laugh at first but it's a great question to get them thinking.
Paraplanner. F1, Apple, Nutella, ice cream. No trite motivational quotes. Turning a bit northern.
Surely any reasonable risk profiling questionnaire should cover tolerance for loss e.g. by how much could the total value of all your investments go down before you would begin to feel uncomfortable.
We use FinaMetrica and this is one of the questions. As the question is framed amongst others which deal with other types of risk and reward, it is therefore not isolated. Asking a client how much loss they can tolerate without context of reward (which I appreciate is probably being done anyway) will generally lead to clients having very low tolerance for loss.
And agreed, capacity for loss is not measured by any questionnaires I have seen.
What confuses matters is that questionnaires tend to ask the client what they think their CFL is.
Capacity for Loss is not about losing sleep, it is about how much the client can afford to lose before it starts to impact their lifestyle. You could have a clients whose attitude to risk is high, but they cannot afford to lose any of it and vice versa, you could have someone who has an unlimited capacity for loss, e.g. they could afford the entire investment but does not want or need to take investment risk.
In my mind, the capacity for loss should be assessed by the adviser based upon known facts about income and expenditure. If you have sufficient guaranteed income to cover your expenditure, then you can afford to lose all other investment assets. I make it clear in the report that this is not to say that the client would be happy to lose 100% simply that they could afford to without it impacting lifestyle.
If you are using drawdown to fund income, then I agree with @richallum, you use cash flow to stress test the scenario.
I think we need to step away from using risk profilers for assessing capacity for loss as it is not a feeling (That is attitude to risk) it is factual and whilst you might not be able to put a number on it, you can provide a general statement that says things like, you could not afford to lose any of this money before it impacts your lifestyle, you could afford to lose a small amount etc....I suppose you should define small.
I like @richardgough idea of asking what the biggest loss they ever had was and how they felt. Then what happened? Did they stay invested and see it recover or did they bail? This should help you put a number on the tolerance aspect of risk. However, as you can't guarantee anything you're reliant on robust historic data to then use a fund/portfolio that should behave in line with expectations.
Also, if you are using cashflow then you can establish what return they need to meet their objectives and invest toward the lowest risk portfolio needed. This should give them peace of mind that you're only exposing them to the risk that they need, even if they could tolerate and have capacity for more.
I agree with @richallum and @Nathan this is all about cashflow