How Do I Measure Risk?

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What risks are you prepared to take

What risks are you prepared to take?

So, what risks ARE you prepared to take?

Some people think it is fun to bungey-jump off a cliff or a bridge or a crane when they are travelling overseas, while others are not prepared to do this – whether it be from fear of heights, concern over the health effect on their eyes or their brain, worry about the abilities of the operators, the durability and dependability of that incredibly thin piece of rope or just a horrible memory of a previous fall from a height.

If you were to measure the psychological profile of every ‘jumper’, would you find that they are mostly high risk-takers in other parts of their lives? What of those who otherwise measure as ‘super conservative’ with the rest of their lives, yet still take the step over the 100 metre void? How do you explain their actions? Is the fact that this is a holiday trip, away from the safety and conformity of ‘home’ making a difference to their acceptance of the suitability of risks (‘holiday romances’ being a standard phrase would suggest that it is…).

This question is posed often by financial advisors and investors. This particular post was prompted by a similar question from Mark (you thought i’d forgotten, didn’t you?), and Jacqui (who was shocked to learn that her financial advisor was comfortable with the risks of regularly riding a motorcycle).

It was finally pushed into being by the recent release of guidance from the UK’s Financial Services Authority (FSA) that actually puts in writing thoughts and ideas from the regulator. This is so overdue that it makes my sides hurt just thinking about it. Here in Australia, the regulators are leaving it up to every market player to decide on what is the appropriate way of measuring risk, and allocating appropriate investments. This results in a market flooded with biased, inappropriate systems and procedures such that your correspondent is only vaguely surprised when biased ‘Industry Fund’ advertising and political lobbying campaigns gain the traction that they do. The UK regulator has taken the unusual step of actually trying to walk in a planner’s shoes, and come up with something that can be implemented in the real world. For example, on page 10 of their report they analyse ‘risk-profiling tools’, and find that 9 of the 11 tools considered had a high probability of outcomes differing from the likely client expected outcomes.

As a result of all this regulatory change and scrutiny, Barclays Bank in the UK is closing down its ENTIRE financial planning division – putting out of work (reassigning/retrenching/sacking) 1,000 planners and staff. It is likely that the £67.7 million fine and compensation payments levied by the FSA on Barclays for inappropriate investment advice would have had some part in the decision to close the financial planning operation.

So, this post is an attempt to bring a little bit of clarity to the overall picture of measuring risk for the individual. It is a broad topic, so there is every chance this will only be the first of a series of comments but we have to start somewhere, don’t we?

In Australia, there are so many authorative and compelling voices competing in this space that it is nigh on impossible for the individual to make a coherent investment risk/return decision based on the material generally available. And my argument here is that this exact same difficulty exists for financial advisors. Shock and horror! Surely not? Aren’t advisors trained in exactly this area? Well… yes. And yet there are blocks to perfect knowledge that are probably more important to know than the details of the outcomes of risk measurement itself. If you can set aside a little bit of time, we will work through those statements, and attempt to clarify some of the noise, distractions and roadblocks to good risk measurement.

But before we do – let’s ask ourselves why this is even important? Where would the average person possibly need to know anything about this? How about the following:

  •  You have to sign a form to join a super fund at work, and it asks you which investment option you want to select. How do you make that choice?
  • You run your own superannuation fund, and have an “investment strategy” provided by your Accountant/ Financial Planner/ Fund Administrator. After a while, you decide that maybe you’d like to have a strategy more specifically tailored to your objectives,
  • You have done well financially so far. You have a nice home, vehicles and a lifestyle that makes you happy. What debt you have is well controlled within the income you earn, and now you would like to take a ‘next step’ to improve the return on your surplus funds.
  • The house is paid off. You have money in the bank, and are saving more each month. Now for the big step – what next?
  • You’ve started with a new job. There’s a flash new car sitting in the carpark and planning for your next overseas holiday is well under way. You’ve put money aside for super but there’s more that you can do, so now you want to weigh your options a little more carefully.
  • Retirement is on you. The money you have now is all that you will ever have because you aren’t or can’t go back to work to top it up. This is a ‘circle-your wagons’ moment. How are you going to deal with your money? How are you going to let others deal with your money – if at all?

Again, before we go any further, please note this site’s standard Warnings and Disclaimers. Nothing on this site is to be considered personal financial advice. You cannot rely on any of this material to make a financial decision, without first either consulting an appropriately qualified professional advisor or personally taking into account your own financial position, objectives and attitude to risk. There, consider yourself warned.

The starting point for looking at your attitude to risk is to clarify just what outcomes you are looking for. From this the range of available options can be tabled, and this listing can be further filtered by your preferences, knowledge, understanding and bias. This still does not guarantee that the outcomes will be what you want or that you will be comfortable with the outcomes that are achieved. It simply means that you have gone into the area with your eyes open, and the best information being available to you to help make your decisions on direction.

 You should also consider this note as just one more note amongst many – here are a few examples of areas where you can learn a bit more about the issue of risk and return, as it applies to the individual.

  • MoneySmart – the new Government website providing broad general financial advice
  • Finametrica – these people distribute what is probably the most academically robust financial risk profiling system available. The site includes examples of the types of questionnaire that is used, and a sample of the report that is produced. For Australian users, the charge is currently $55 per report.
  • Your existing super fund website. Many super funds now include broad “risk guides” or calculators that help you assess which category of risk you would most likely fit into. Please keep in mind that these guides are predominantly focussed on helping you assess between the options that the specific fund offers – they are not usually very specific on anything outside of this limitation.

 So, what outcomes are you looking for? For financial planners, this boils down to a few ‘categories’ of similar objectives:

  • A regular income
  • Growth in the price of your investments
  • A mix of the income and growth
  • A specific sum of money, at a specific time.
  • A total return over the rate of inflation, to make sure your money keeps up with rising prices of the things you want to buy

That’s not too comprehensive but it is a good start. You may have much more specific outcomes but right now we will just consider those shown above.

Now you need to look at the range of options available to you. Remember, at this stage you aren’t looking to apply filters for things you do or don’t like. You are looking at what you CAN do.

Let’s start with a regular income, and work the example through just to see how the process works. The range of options available to you include :

  • Interest from cash in the bank.
  • Term deposits, with interest paid monthly, quarterly, at maturity or on some other basis.
  • Commercial, residential, industrial, leisure or office property. You would expect that any could provide a solid rental income to you from the contracts tenants sign.
  • Listed shares or securities. This could include shares in companies right through to fixed income notes and other types of fixed income investments.
  • A business income. You could invest directly into a business and earn an income from the profits of the business.
  • Trading activity. You could earn money buying and selling bric-a-brac at local markets; trading shares, gold, silver, antiques, collectables and works of art. The money you have available for investment is used to set up the operations or provide working capital go help you earn that income target you are after.

 If you can come up with more alternatives, just add them to the list.

Now you can start to apply a few ‘filters’ that will help to clarify which of these options is plausible and potentially appropriate. To do this, you consider some of the limitations to your capacity and abilities. A few examples :

  • How much cash do you have available as starting capital?
  • Are you likely to be able to add to this in the future? How about regular additions?
  • Is there a minimum level of income that you need to earn, and how regularly will you need to receive it?
  • How much knowledge and experience do you have in each area?
  • How much time to you have available to establish, monitor and maintain whatever you end up buying or investing into?
  • Do you need to get some of your original money (“capital”) back at some stage? How much, and when?
  • If you are looking at trading activities, what knowledge, experience, training or skills do you have, and how much certainty is that likely to provide to the level of income you will receive?
  • How much variability of income can you comfortably deal with (ie, and still live the lifestyle you are wanting to live?)

OK. Now we are getting somewhere. Just working through this listing should begin to knock some of the options out of contention.

 Notice that we haven’t worried about “form” or “structure” yet? For example, we are not concerned with whether an investment is held in your name, joint names, through a company or a trust. Nor have we isolated whether it should be held in a superannuation fund account or some other such tax structure. All we are looking at is what is workable and what is plausible, and what is not.

At this stage you may be wondering where on earth the measure of risk stands? Well, we have to know what is possible and acceptable for our basic criteria first, and that is what we have been doing.

 For the moment, we’ll leave it at that. As you can tell, there is a lot to cover, and many opportunities for poor communication to result in misconceptions or misunderstandings. Just keep a cynical hat on, and remember that anything as difficult as measuring risk is going to take a while to get your head around. If you doubt me on that one, consider the difficulties the world’s foremost risk rating agencies had in measuring and communicating risk levels for financial products prior to the Global Financial Crisis…

 


 

Michael’s Soapbox Rant in italics below – so you can choose whether or not to bother reading it…

In my opinion, the result of the Australian regulatory approach is a ‘lowest common denominator’ approach to financial planning. All financial planners must be affiliated with a ‘Dealer Group’, and the majority of planners -one way or another- work for one of the 4 major banks. These businesses need to implement the highest profit/lowest risk procedures into their business model, and this results in ‘vanilla’ planning. In other words, the entire country fits into one of 5 investment categories (or six or seven. Regardless of the specifics, the end result is that every investor MUST fit into one of those categories, and there are specific portfolios associated with each category. That way, you can tailor your selling strategies to meet the traditional X contacts for Y meetings for Z average fee equals $D profit per planner). This is exactly what the Industry Funds are telling us as well – all the time arguing that this or that change to the regulatory framework is aimed at reducing bias. If my words sound harsh, just ask yourself why Industry Fund member fees are being used to support campaigns aimed at non-superannuation outcomes…? The bias in funds management and planning is entrenched in entirely different ways to those current legislation activity is targetting.

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