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The journey of risk regulation: Don’t forget the investor

Risk tolerance cannot be accurately assessed by putting complex risk-return choices in front of people, or asking them to choose between possible portfolio outcomes in the distant future. As humans, we simply don’t know how to judge the level of risk we’re prepared to take over the long term. Risk tolerance, as a personality trait, arises from the psychology of the person, not from an incoherent bundle of attitudes to component investments.

And whilst an individual’s risk appetite is important, it is far from everything that is needed to establish the right level of portfolio risk. Risk tolerance needs to be woven together with measures of risk capacity, which for most clients is the more important of the two. Required by the regulator, but frequently given no more than lip service by the industry, risk capacity requires integrating knowledge of an investor’s entire balance sheet (including assets as well as liabilities; and investible assets as well as non-investment holdings) with knowledge of their anticipated future income and expenditure. A well-designed risk capacity framework, of which there are few good examples, permits the appropriate investment risk profile to be updated dynamically as circumstances, plans, and goals change – even as risk tolerance remains constant (as it generally should, if measured correctly).

When it comes to the measurement of investment risk via historic volatility, often the approach fails to recognise that:

  • risk, as it is meaningful to investors, is about the chance of downside, not variability;
  • risk is about long-term outcomes, not fluctuations of value on the journey;
  • risk is not adequately reflected by information about the recent past – indeed, there is no such thing as risk in the past, only volatility;
  • risk is a feature of the client’s portfolio, not individual products therein;
  • and risk is particular to the individual investor, and so needs to account for their particular combination of risk tolerance, risk capacity, and financial personality.

If organisations are to ensure they are providing the right level of risk for their clients, they need to stop pretending that it is possible to arrive at accurate measures of risk for individual investments ‘bottom-up’. The more granularly we try to measure risk, the less credible the measures become. Instead we should turn our attention to robust frameworks for assessing the suitability of clients’ portfolios, though a combination of top-down examination of the overall asset allocation, and bottom up tests to identify concentration risks that could indicate the top-down measure is inadequate.

Assessing risk is difficult, but it is vital that on both the investor or investment side we don’t reach for superficially sophisticated solutions that end up getting things very precisely wrong, rather than approximately right. The best solutions are robust but not over-engineered:

  1. A simple, yet empirically validated psychometric risk tolerance scale that doesn’t rely on spurious revealed preferences or over-engineered quantitative choices.
  2. A dynamic and quantitative risk capacity model capable of coping consistently with variable levels of completeness of client information.
  3. An academically sound algorithm for blending risk tolerance and risk capacity, and dynamically updating the resulting risk profile to respond to changing circumstances and preferences.
  4. A practically and theoretically robust methodology for mapping investor risk profiles onto appropriate investment risk levels.
  5. A suite of psychometric behavioural scales to deepen client understanding, improve client engagement, and manage emotional comfort along the investment journey.
  6. A framework for ongoing monitoring of client portfolios, combining top-down and bottom up tests to establish suitability of the client’s actual holdings without relying on spurious granular risk measurement of individual assets.

 

Greg B Davies, PhD - Head of Behavioural Science, Oxford Risk

Greg is a specialist in applied behavioural finance, decision science, impact investing, and financial wellbeing. He started the banking world’s first behavioural finance team at Barclays in 2006, which he led for a decade.

In 2017 he joined Oxford Risk to lead the development of behavioural decision support software to help people make the best possible financial decisions. Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held academic affiliations at UCL, Imperial College, and Oxford; and is author of Behavioral Investment Management. Greg is also Chair of Sound and Music, the UK’s national charity for new music, and the creator of Open Outcry, a ‘reality opera’ premiered in London in 2012, creating live performance from a functioning trading floor.


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