Risk Forecasting Is A Risky Business

When first meeting with you to discuss any potential long-term investment the first step any professional adviser will take is to gather details of your personal and financial circumstances and then assess your risk profile. Assessing your risk profile will take account of your objectives, attitudes to risk and capacity for loss. With this information in place, the adviser may then suggest a suitable asset mix to deliver on your objectives.

An adviser will often use a risk profiling tool to obtain a risk measurement. If used appropriately this measurement delivers a baseline upon which to base decisions and a level of consistency in the advice offered. Some tools may also provide recommendations on the investment.

Risk forecasting tools have often been criticised. They are software products and therefore the quality of their output is directly related to the quality of the input. They are also based on a number of assumptions and it is critical the adviser understands both something of the computation and the assumptions made. Perhaps the greatest criticism is the tools use of historic data to suggest investment profiles.

Before the ‘credit crunch’ of 2008, the inputs to risk and investment models tended to be relatively straightforward. Long-term data from a number of reliable sources showed that equities (shares) tended to perform better than bonds. A balanced investment portfolio would therefore likely be skewed to equities.

The long-term data, over 50 years (source – Barclays Gilt Study), still shows equities perform better than bonds but since 2008 the situation is reversed with bonds performing better than equities. An adviser blindly relying on the output of a risk measurement tool alone 10 to 15 years ago may have recommended an investment portfolio with a lower than optimal performance with potentially higher risk.

Nobody can be certain what will happen in the future. All that can be done is to make a well- judged assessment based on client profile and objectives, long term experience and the (historic) data available at the time. A consistent process based on inputs from various tools can ensure consistency and give the best chance of success but there are no guarantees.

Using a long term view based on historic data and the risk assessment to deliver a strategic asset allocation as a benchmark then applying a medium term tactical overlay based on the adviser’s experience and assessment of what may happen in future may deliver the best outcome provided costs can be kept relatively low. Relying on risk forecasting and/or automated investment recommendations alone remains a very risky business.

The information in this article does not constitute financial or other professional advice. You should not take action on the basis of this article without seeking regulated independent financial advice that addresses your specific circumstances.