Planning our finances can be a complicated business. You’ll need to review dozens of options, stick to a clear plan and implement it as early as you can afford to. The most important variable throughout will be how much risk you would like to take, this will steer your level of return. Here we try to explain a bit more about the importance of investment risk and the danger of selling out of the capital markets at the first sign of a jitter.
Risk Is Rewarded
Whether investing in general or aiming for a particular goal, whether using a traditional financial advisor or an online investment manager, everyone is asked to complete a risk questionnaire when they sign up. This questionnaire asks some relatively generic questions to understand an investor’s attitude towards risk. More traditional investment managers have four or five ‘risk buckets’, into which they allocate their investors depending on their responses.
Whilst this process has been an industry norm for a while, it lacks transparency and fails to deliver the bespoke experience so many people are looking for. It simply isn’t the best way to assess individual risk tolerance or comfort.
“Risk is the possibility that the actual return on an investment will be different from its expected return.”
For example, imagine you are allocated to the ‘conservative’ risk bucket. What does ‘conservative’ actually mean? How much would your portfolio lose if the market fell 10%? Is there a certain sum you can rely on being left with when you reach retirement?
There are various horror stories that surround investment management – ‘defensive’ portfolios dropping 20% overnight and investors losing their life savings. However, hearing about these horror stories does not necessarily stop us from investing: we are aware that there is a minor possibility that something might go wrong and we feel comfortable with that risk. The exact calculation of this risk has been impossible for retail investors in the past, but now we can compute the precise risk of a negative event occurring.
“Your risk tolerance doesn’t change; but your perception of risk does – which means you make less than smart decisions.”
Everyone has an individual risk tolerance. A more risk-averse investor may find minor market turbulence scary and worry that their portfolio won’t recover from a few bumps in the road. But by selling out at the first sign of a market murmur, the investor is likely to then sit on cash at a 0% return.
“Those private investors that invest for themselves underperform the market by up to 3%.”
The way that traditional investment managers compute risk doesn’t necessarily make our experience any smoother. They often use volatility as a measure of risk which broadly monitors the ups and downs and tells you where ⅔ of the outcomes of the investment will fall between. However, when controlling risk, the downward deviations are the ones to focus on and this is where the use of volatility falls short.
Restoring Trust in Financial Services
While working as a Goldman Sachs trader, I was helping large sovereign wealth funds manage their risk in an entirely different way. This got me thinking about bringing a similar service to the public, so that everyone, from my friends to my mum, no longer had to be lumped into one of five risk buckets. That’s why I built Scalable Capital. I wanted to focus on the thing that we can predict and measure – risk, and not waste time trying to predict what has been proven to be impossible to predict – where an individual stock price will be in a few days or months.
Imagine that you knew the exact downside risk of your investment portfolio and it had been tailored to perfectly suit your appetite for risk. Using Monte Carlo simulations, we model tens of thousands of possible paths that your investment can take and give investors an accurate calculation of downside risk. By better managing risk, we can generate smoother returns for our clients.
When concentrating on downside risk, we use Value-at-Risk (VaR) which focuses on potential losses over a specific period of time. VaR essentially tells the investor how likely their portfolio is to lose a certain percent in a given time period. We keep risk constant so that our clients don’t end up with a ‘medium’ risk portfolio that becomes ‘aggressive’ in a market downturn. We avoid the life savings horror stories by adaptively managing risk – dynamic risk management.
We use the results of the risk questionnaire to allocate investors to one of 23 different, very granular, risk categories – a world away from the five risk buckets discussed earlier. These risk categories are defined by the 95% chance of the returns being greater than a fixed value. For example, imagine if you could invest your savings safe in the knowledge that there was a 95% chance that your portfolio would not fall by more than 15% in one year. Using our sophisticated technology, we can dynamically adjust portfolios to avoid losses resulting in higher risk-adjusted returns.
Are You Aware of the Risk of FTSE, Euro Stoxx 50 and S&P 500?
As with all other industries, it is only natural that investment management continues to evolve and risk management tools become more sophisticated. By carefully managing downside risk we can give our clients a precise probability for loss – a first in the retail industry. Our clients can remain calm, even in times of turbulence, safe in the knowledge that their portfolio isn’t going to breach their agreed appetite for risk.
*(Confidence level: 95%, retention time: 1 year, calculation period: 02.01.1997 to 30.12.2016, except for FTSE UK Gilts which covers the 18.11.1998 – 30.12.2016 period)
Disclaimer: With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Please note our risk warning on our website.