For a financial adviser, there is a clear difference between a client’s attitude to investment risk and their capacity for investment loss. But how can advisers confidently assess this to ensure that they protect the interests of their clients? We’ve assembled a 5 step guide that will ensure that an investor’s true capacity for loss has been taken into account as part of the advice process. We’ll start by considering what exactly is meant by ‘capacity for loss’ and where, in the advice process, it is likely to be discussed. Then we’ll look at examples of circumstances which are likely to affect a client’s capacity for loss. Finally, we will consider what help is available to assist with this part of the advice process.
1: Understand what is meant by capacity for loss
Risk profiling is intended to establish the amount of investment risk a client is willing and able to take. Their willingness to accept risk (their “attitude to risk”) is normally identified through the completion of a psychometric risk questionnaire. This results in a score that determines the client’s provisional risk profile. Capacity for loss, however, reflects the client’s ability to accept the level of risk identified from the attitude to risk questionnaire. It takes account of circumstances in the client’s life that could affect his or her capacity for loss, either now or in the future. The outcome of the risk questionnaire may show that a client is willing to accept a very high-risk investment strategy, but this may be completely unsuitable if the entire investment represents their total life savings. In fact, where a loss of capital would have a materially detrimental effect on a client’s standard of living, the FCA requires this to be taken into account in the assessment of the risk the client is able to take.
It is also important to appreciate that a client’s capacity for loss may differ according to the ‘pot’ of money being considered. For example, a pension fund that is not required for, say, 30 years may be treated quite differently from money needed for a child’s education in 10 years’ time.
2: Understand where capacity for loss sits in the advice process
Establishing a client’s risk profile is an essential part of the advice process. This advice may include the introduction of new funds to a portfolio or the redirection of existing investments to new funds or products. Risk profiling and capacity for loss forms part of the fact find process which is likely to consist of the following elements:
3: Assess the factors that can affect a client’s capacity for loss
A number of factors could impact upon a client’s capacity to accept investment loss, such as:
Proportion of wealth to be invested. Suppose, for example, that there are two investors, each with £50,000 available to invest. With client 1 this represents 90% of their entire liquid assets. For client 2 it is just 20%. Based solely on this information, client 1 is in a more vulnerable position if the value of their new investment was to suddenly reduce.
Financial dependents. The number of dependents should be taken into account as well as the likely period of their dependency. For example, a client with a young child is likely to have a much greater level of on-going commitment than one whose child is about to leave university and move straight into a job. Another factor could be a client having a child who will always be dependent on them, maybe due to physical or mental illness.
On-going financial commitments. The amount and time period remaining for outstanding debts, such as mortgages, should be taken into consideration. For example, will the money currently being considered for investment be needed to repay some or all of these liabilities?
Emergency funds. It is generally recognised that, before committing money to long-term investment, consideration should be given to short-term emergency situations where cash is likely to be needed. The availability of cash could have a significant impact on a client’s capacity to accept investment loss. If, for example, money that is invested is needed at short notice, then the potentially greater short-term volatility of a higher-risk investment may be inappropriate for certain clients, despite their attitude to risk.
Day-to-day living expenses. A client’s dependency on their investments to supplement on-going income is the main factor here. Potentially, the greater the reliance on capital to support income then the lower the client’s capacity to accept investment loss is likely to be.
Investment experience. The level of understanding about investments that a client has, based on previous experience, may also affect their capacity for loss. The greater their knowledge, the more they are likely to appreciate the impact of risk on future returns.
These factors are not intended to be an exhaustive list. They do, however, highlight the importance of a detailed discussion between adviser and client before any investment decisions are made. These are all points that can be identified and discussed during the fact finding process. A client’s attitude to risk is normally derived by the completion of a psychometric risk questionnaire, with a choice of responses offered. The answers, given by the client, result in a score being allocated which corresponds to a specific risk profile. It is, therefore, a formulaic process based on parameters set out by the risk profiling system being used.
4: Develop a process to establish capacity for loss
Capacity for loss is a client’s ability to take on investment risk in reality and should be treated quite differently from their attitude to risk. Good practice requires a company to use one process to assess a client’s attitude to risk and a separate process to assess the client’s capacity for loss, whilst ensuring both are appropriately considered as part of a suitability assessment.
No scoring system is involved when establishing a client’s capacity for loss. Instead, a discussion is held between adviser and client. This discussion should focus on particular aspects of the client’s circumstances that currently, or may in the future, impact on their capacity to take investment loss. One method may be to use additional capacity for loss questions which are included separately but form part of the overall risk suitability process, such as those shown. In order that an audit trail can be demonstrated following any advice given, advisers should ensure that the client discussion is fully documented, as shown in this example.
5: Help the client identify his or her capacity for loss
Agreeing a client’s capacity for loss is very much an individual consideration. Two clients with seemingly similar requirements may end up with different risk rated solutions after an in-depth discussion, due to their own specific circumstances. Let’s consider the following two clients, for example:
- Both are 60 years of age and have £100,000 available to invest. Each has an attitude to risk rating of ‘7’ out of 10, using the EValue ‘standard 10’ risk benchmark
- Client 1 has £10,000 available as emergency funds whereas client 2 has £50,000
- Client 1 has little previous investment experience; client 2 has regularly made her own investment decisions
Based on these details alone, it would appear that client 2 has greater capacity for loss and should therefore be advised to take a more adventurous approach to their investment. However, there’s some further information about each client that needs to be taken into account before any investment decision is made:
- Client 1 has no financial dependents; client 2 has a disabled son aged 25, who will always be reliant on her
- Client 1 has no on-going financial commitments; client 2 has a mortgage with an outstanding balance of £90,000.
It is now less clear which, if either, client has the greater capacity for risk. This emphasises the point that a thorough and properly documented discussion is essential before a final outcome can be confirmed.