Attitude to risk is psychological. It's the part you'll see classed as psychometric testing from the tools that are available. It's subjective, so it's about feelings and personal bias, and it's a willingness to take risks.
Capacity for loss is the ability to absorb loss until it impacts the standard of living. It's objective, so its fact based, and it’s the ability to take risks, not a willingness.
Individually they are quite different in terms of what they are measuring but the combination of the two is what drives the underlying clients risk profile.
ASHL network give our advisers access to three risk profiling tools and it’s purely down to the firm to choose which one you work with.
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EValue
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FE Analytics
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Defaqto
When you're looking at risk with clients, you need to make sure you have a consistent definition throughout the whole of your advice process.
When a client first comes to you, they will have various assets etc, how are you going to ascertain the level of risk inherent in the client's current portfolio? The next stage, is to think about how you are going to assess the risk of that individual from an attitude to risk and capacity for loss perspective and, finally, what is the risk of the proposed investment solution? If you are looking to align it to an alternative solution, how are you ascertaining what the level of risk is of that solution?
For example, you could have a situation where a clients’ current portfolio is a seven out of ten in simplistic terms, their actual assessment of risk is a five, so you want to align them to a portfolio that is five out of ten.
That's why it's important to make sure you're working off the same tool for all those relevant points, but equally, ensure alignment with the other tools you use, as well.
If you're using cash flow modelling, you ideally want the definition of risk, or the way in which risk is interpreted, to be similar throughout, to avoid any ambiguity in the work that you're carrying out for clients.
EValue
EValue risk methodology is based on the current asset allocation. The efficient portfolios are based around capital market assumptions for the various asset classes. They use historical data to form an opinion of asset classes, but they are forward looking assumptions, based over a 10 year time horizon.
What they're effectively saying is, for example, UK equities are expecting a growth rate of X and volatility of Y on the asset class. What’s happening here is you are combining the various asset classes with those assumptions and seeing where a solution would fall within their risk bands.
The EValue risk scale is 1-10 but it is time frame based, and there are five timeframes. It's asking you to work with your client and decide what is the correct timeframe or the likely length of their investment out of 5 time frames, and the asset allocation will vary, depending on the time frame.
FE Analytics
FE Analytics utilises EValue, using the 1 to 5 risk profiling questionnaire. However, the way in which they quantify risk is quite different because it's based on historical volatility over a 3-year period, but it must have a minimum of 18 months to qualify for a risk score.
For example, say that the risk of the portfolio is 62. What does that mean? Well, what it's saying is that the risk score produced is a comparison to the FTSE 100. Effectively, it's putting more focus on the shorter term, as opposed to the longer term, over that 3-year period, so older values, carry less weight.
The risk score bands, decide the risk profile of the solution. So effectively, if you’re a 62, then there's 3 timeframes. If we go for the longer timeframe, which is 15 years plus, effectively, you'd see where 62 sat in the risk band scale and let's say that it’s a 3. It's a 3 out of 5 in that example.
They do set the original risk boundaries based on the EValue asset allocation from outset. But the way in which they're calculating risk ultimately is quite different. This is why it's important not to jump between tools. But for anybody who's running their own portfolios, FE Analytics is the right tool for you.
Defaqto
Defaqto is based on the current asset allocation similar to the way in which EValue operates. Its future values for volatility and returns are taken from Hymans Robertson and they're 10 years forward looking, again, by definition, they're going to look at historical data of asset classes but then there is a forward-looking assumption for volatility and returns. The output is matched to the Defaqto volatility bands, so it’s where that portfolio then sits within the volatility bands which dictates which risk profile between 1 to 10.
The difference here with Defaqto is that there are no time frames. It’s 1 to 10, and it's not short, medium, or long, It's just 1 to 10. So, by definition, if you’re with a client that had a shorter timeframe, then you would have a discussion with them and if it was appropriate, lower, the risk for that portfolio.
You'll probably see, there are some solutions that are ‘officially’ risk mapped. The only difference here with Defaqto is if the solution is officially risk rated, rather than it just being quantitative based, a qualitative overlay is included. It is the highest of the historical or forecast portfolios volatility.
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