Risk-on, risk-off… Risk appetite, risk tolerance, risk capacity, risk required. What on earth do all these terms mean, both to investors and to financial advisors? Or has the jargon become so over-used and jumbled that most investors, and perhaps even advisors, are simply left confused?
Misperceptions about what risk means are common, and they are in fact downright dangerous. They are — excuse the obvious old-school reference —risky business (except that Tom Cruise doesn’t feature).
We’ll explain, using one of our favourite comparative scenarios.
Let’s suppose that 45-year old Katy is looking at buying a car. She visits a dealership. The dealer suggests that she take a Ferrari for a spin. Katy’s appetite is for the red-hot Ferrari. Not only would this be “tolerable” to Katy, but it would also be a dream come true! The dealer’s preference is to sell her the Ferrari, but he has little idea that Katy is a terrible driver and a speed demon. Katy’s driving skills actually call for an old-school sedan, preferably one that can go no faster than 80 kilometres per hour. This is her capacity, taking all of the circumstances into account. Katy, however, often needs to drive long distances, so a vehicle that can only hit 80 km/h on the freeway…well, it would simply not be practical. She requires a car that can reach at least 120 km/h.
A scrupulous dealer would take all of these factors into account, as well as Katy’s financial situation, and importantly, her insurance. If the car Katy intends to buy is her risk, then her insurance could be one form of risk-mitigation. And when it comes to risk, just as when it comes to buying a car, it is crucial to note that it is not only a person’s financial circumstances that determine their risk tolerance, risk capacity and/or risk required. There are several factors, including the psychology of the person (Katy is a speed-demon), the risk-mitigating mechanism (insurance) available, and externalities (such as Katy’s job).
In a perfect world, an individual’s tolerance for risk, their capacity for risk and their required risk would dovetail. In investment, we call these three things their risk-profile. But in the clearly imperfect world we live in, this is seldom the case. There is usually a compromise. A risk-averse investor (tolerance) may need to take on more risk (requirement) to achieve their desired level of return or may be unable to afford (capacity) the level of risk that they feel they could stomach (tolerance).
Particularly in a world where interest rates are at record lows, and traditional safe-haven assets are yielding low returns, investors have sought yield from riskier asset classes. These may include hedge funds, alternative investments, unlisted property, and stock markets (in developed and emerging markets). The associated risks are essential for investors to understand, aligned to what is required to generate their desired level of return.
Retirees, who have faced a double-whammy from the low interest rate environment and from Covid-19-induced market volatility, need to pay particular attention to their risk-profile. Here, the time they have until their retirement is likely to play a role as well. A younger retiree is likely to have a higher capacity for risk, as they may be able to “wait out” market downturns. Their pension fund investment may have a higher allocation to traditionally more risky assets. A wealthier or more fortunate individual may have alternative sources of income, which could be regarded as akin to the insurance in the car example. They may have both a higher capacity and greater tolerance for risk, as they are not solely reliant on their pensions for income. A pensioner who has a higher level of desired income (perhaps because they need to pay the instalments on their Ferrari) may need to take on (require) more risk than they are inherently comfortable with, provided they have the capacity to withstand a temporary or permanent loss of capital. There is some trade-off necessary between their risk-tolerance and risk-requirement.
Our example was highly simplified, but it can provide a useful way to think about any intimidation jargon surrounding risk. When it comes to financial discussions, risks are sometimes seen as “bad”. In the process of buying the car, Katy’s personality, her financial circumstances, and her job requirements all helped to determine her risk-profile. None of these elements are good or bad, they are just part of the natural process. Risk is part of the investment process.
In general, however, and in particular when it comes to pension fund investing, individuals are likely to need assistance getting to grips with the jargon and with their own risk-profiles. This may require intentional education campaigns, or individual one-to-one discussions, depending on the level of sophistication of the investor and the scale of the investment. Advisors and trustees need to see it as their fiduciary duty to help investors reach the necessary understanding.
– Fran Troskie
Investment Research Analyst, RisCura