Investor Compass User Guide

The following short articles will tell you everything you need to know about how to use our software and what to do with the outputs. 

Financial Personality

Every investor has their own unique set of preferences when it comes to their finances. This goes beyond Risk Tolerance and includes how Confident they are, their emotional capacity to endure market stress, and much more. We call this collection of preferences their Financial Personality.

Some of these personality traits like Risk Tolerance are important for satisfying regulations, whilst others such as Composure help you to understand how investors are likely to feel and behave over the investment journey. These rich insights help you to tailor your investment recommendations and deliver a more personalised service.  

Risk Tolerance

Risk Tolerance is an investor's long-term psychological willingness to trade-off risk and return and it is the starting point for establishing the right level of risk to take withInvestible Assetsover the long-term.

The Risk Tolerance assessment places investors intocategoriesrelative to the baseline investor population. The results typically follow a normal distribution so you can expect more medium risk investors and less lower and higher risk investors.  

The assessment follows a psychometric approach based on leading scientific and behavioural finance principles. Studies show this is the only accurate and robust way of measuring investors’Risk Tolerance which means you can be confident in the outputs. 

The questions are designed to be easy to understand sowe deliberatelyavoid questions which test mathematical ability or require a deep knowledge ofinvestments.There are no right or wrong answers and you should encourage investors notto over think the answersandto go with their gut response. 

Inputs

Here are the Risk Tolerance questions. 

Questions	I am more prepared to take investment risks than other people.
	I am willing to put a significant part of my wealth in high-risk investments.
	​I would risk losses to get potentially greater long-term gains.
	​I am prepared to participate in market downturns and upswings rather than receive more consistent annual returns.
	I am comfortable with uncertainty when investing my money.​
	​I am comfortable with the possibility of ending up with less than I expect, for the chance of ending up with more than I expect.
	​If there is a chance of making better long-term returns, I am prepared to take higher investment risks.
	​I expect higher investment growth and I am willing to accept a higher possibility of large losses.

Outputs 

The Risk Tolerance assessment places investors into 5 categories from Low to High. But we are sometimes asked to provide 7 Risk Tolerance categories in which case we add a Very Low and Very High category. 

Very Low	You have very low risk tolerance, which means you tend to be highly conservative with money, and prefer security over the possibility of growth.
Low	You have low risk tolerance, which means you tend to be conservative taking financial risks. People with low risk tolerance are most comfortable when their total wealth is mostly protected against the possibility of poor long-term outcomes, even if that means lower returns. The suitable level of risk for your investible assets also depends on your risk capacity.
Medium Low	You have medium-low risk tolerance, which means you tend to be cautious taking financial risks. People with medium-low risk t​​tolerance want their total wealth to grow, but they are reluctant to accept a substantial possibility of poor long-term outcomes. The suitable level of risk for your investible assets also depends on your risk capacity.​​
Medium Low	You have medium risk tolerance, which means you take a balanced approach taking financial risks. People with medium risk tolerance neither seek nor avoid financial risk, and they are prepared to accept uncertainty if it means they are likely to make a decent return on their total wealth. The suitable level of risk for your investible assets also depends on your risk capacity.
Medium High	You have medium-high risk tolerance, which means you tend to be assertive taking financial risks. People with medium-high risk tolerance want to grow their total wealth over the long term, and are willing to accept the risk of poor outcomes to do so. The suitable level of risk for your investible assets also depends on your risk capacity.
High	You have high risk tolerance, which means you tend to be ambitious taking financial risks. People with high risk tolerance are comfortable accepting the risk of getting less than they wanted if there is a chance of getting much more than they hoped. The suitable level of risk for your investible assets also depends on your risk capacity.
Very High	You have very high risk tolerance, which means you tend to be adventurous taking financial risks. People with very high risk tolerance are comfortable accepting the risk of getting less than they wanted if there is a chance of getting much more than they hoped. The suit​able level of risk for your investible assets also depends on your risk capacity.​​

How to use it

Risk Tolerance is the starting point for establishing the right level of risk for investors to take with their Investible Assets. 

But you should considerinvestors’ Risk Capacity (or Capacity for Loss), their Knowledge and Experienceand Composure when selecting the Suitable Risk Level (the right level of risk to take with Investible Assets). 

We talk more about how Risk Capacity, Composure and Knowledge and Experience impactinvestors’ Suitable Risk level in the following sections. 

Consistency

There is a consistency assessment which checks that investors have answered similar Risk Tolerance questions in a similar way and any conflicting answers are flagged for further discussion with the investor. There is also a timer so that you can check that investors have given the assessment an appropriate amount of attention. 

If investors have answered similar questions in an inconsistent wayyou should check that the investor understood the question and answered as they intended. If the investor has made a mistakeyou can edit their response or create a new assessment using the quick fill function. 

Outputs

Green	The questions were answered in a consistent way.
Amber(all answers the same)	You have selected the same answer for every question. This isn't necessarily a problem, but you should check that you understood all the questions and agree with your profile results.
Amber	Looking at the pattern of your answers, some questions stood out as being different from the rest. This result isn't necessarily a problem, but it's important to check that you understood every question, are confident in your responses, and agree with your risk tolerance result.
Red	"Looking at the pattern of your answers, some questions stood out as being much different from the rest. This result isn't necessarily a problem, but it's important to check that you understood every question, are confident in your responses, and agree with your risk tolerance result."

Composure

Short term investor behaviour is a drag on long-term investment performance and the average investor forgoes 3% of returns each year due to the need for emotional comfort. Soa big part of an advisers job is to help clients get invested and stay the course.

Composure is a behavioural insight which helps to identifywhich investors are likely to be more anxious and jittery over the investment journey. Lower Composure investors are likely to be more reluctant to invest, and are more at risk of buying high and selling low. 

Composure is different from Risk Tolerance, because it is more about short-term emotional reactionsto fluctuations in the value of investments, whereas Risk Tolerance is more about a well-considered view of the balance between long-term risk and return. So, it’s possible for a client to have high Risk Tolerance, and low Composure – although this would be an especially difficult combination to have. 

Inputs

Here are the Composure questions. 

Questions	I get worried when my investments drop in value.
	I would worry about losing money on financial markets.
	I would worry about my investments frequently fluctuating in value.
	The possibility of investment losses makes me uneasy.

Outputs

The assessment places investors into three Composure categories from Low to High. 

Low	You have low composure, which means you may be made anxious by the temporary ups and downs of the market, and be more likely to trade too frequently, or to buy high and sell low. You should not invest in any portfolio that is too far above your risk tolerance.
Medium	You have medium composure, which means you can occasionally worry about the temporary ups and downs of the market, though this may only be a problem when things become particularly stressed.
High	You have high composure, which means you are relatively unaffected by the temporary ups and downs of the market, and stay focused firmly on the long term. However, this can mean you don't pay enough attention at times, or don't take the time to ensure your overall wealth is properly organised and invested.​​​

How to use it

Composure moderates the extent to which you should increase the Suitable Risk Level, relative to the investor’s Risk Tolerance, for those investors that have High Risk Capacity. 

Investors with Low Composure are likely to panic and worry more when markets falland as a result it may be less appropriate to increase risk relative to Risk Tolerance. In some cases it mightbe better to adopt a lower Suitable Risk Level to help investor’s stay the course, even if this means accepting lower long-term returns. 

Investors with Low Composure may also need more guidance and hand holding to get invested and to stop them from selling at the wrong time. You should educate Low Composure investors for the inevitable times when markets fall by reinforcing that investing is not a smooth journey using visualisations and explaining how the portfolio could perform in a down turn.If stock market do fall sharply you should contact lower Composure investors first as they will be worrying more and are more at risk of selling into a falling market. 

Investors withHigh Composure are less likely to panic when markets fall and may even see a market correction as a buying opportunity. If an investor has High orMedium Composure and their Risk Capacity is High, it could be suitable to increase their Suitable Risk Level relative to their Risk Tolerance. 

If you use the Financial Circumstances Assessment, the investor’s Risk Capacity score will automatically increase or decrease the Suitable Risk Level relative to Risk Tolerance.If the Financial Circumstances Assessmentis not usedyou should make your own assessment of Risk Capacity and pick a Suitable Risk Level taking into account the investors Composure and Knowledge and Experience. 

Confidence

Confidence is a measure of how capable and comfortableinvestors feel about their ability to make good financial decisions. Confidence is also an indicator of potential vulnerability.  

Inputs:

Here are the Confidence questions. 

Questions	I am an experienced investor.
	I am well informed about investing.

Outputs:

The assessment places investors into three Confidence categories from Low to High. 

Low	You have low confidence, which means you may have limited experience with investing, be relatively unaware of current market conditions, and might require more guidance or background information when considering your options.
Medium	You have medium confidence, which means you tend to be reasonably sure in your ability to make good financial choices, but may occasionally feel uncertain about the best course.
High	You have high confidence, which means you are generally happy making complex choices, considering a lot of information, and weighing many options.

How to use it

Confidence impacts the Suitable Risk Level indirectly by feeding into theinvestors’Knowledge & Experience score. 

Investors’with lower Confidence are likely to have lower Knowledge and Experience and if Knowledge and Experience is Low or Medium, it might be appropriate to reduce investors Suitable Risk Level, until sufficient experience and Confidence is gained. 

Users of the Knowledge and Experience and Financial Circumstances assessment will find that the system automatically adjusts the Suitable Risk Level to account for Confidence and K&E.  Advisers who don’t use these assessments should consider investors’ Confidence as part of the their own K&E assessment and in turn how lower levels of K&E impact the Suitable Risk Level.  

Confidence also indicates how much help investors might need and investors with Low Confidence are likely to require more guidance and support.You should also avoid burdening Low Confidence investors with too much choice and complexity and it is better to focus on the bigger picture and discuss long-term goals rather than focussing on individual investments and short-term performance. 

Conversely investors with High Confidence are likely to be comfortable making investment decisions and may even want to be involved in the decision making process. High Confidence investorsare likely to be more interested in the underlying investments and comfortable discussing technical information and performance. 

Knowledge & Experience

The Knowledge and Experience assessment is designed to make sure that clients understand the risks of what they are investing in. 

The assessment measures K&E acrossfourkey areas - Investor Knowledge, Investment History, Investment Sense,and Confidence. Each area is scored individually and thenpulled together into an overall K&E rating.

Investor Knowledge invites investors to rate their own knowledge of investing and back this up by selecting how they acquired their knowledge. The Investor Knowledge score takes the lower of the two answers. So if a client rated themselves as an expert, but had only acquired their knowledge from reading articles, their Investor Knowledge would be Low. 

Investment history assesses whether investors have held equities, bonds and investment property and over what time periods. Longer time periods result in higher scores. 

Investment Sense gently tests investors’ knowledge of some basic investment principles. The rating is based on the investors minimum response, so if they disagree with any of the principlesthey will get a Low Investment Sense rating overall. 

Inputs

Here are the Knowledge and Experience questions. 

Investor Knowledge	NONE	BASIC	REASONABLE	EXPERT
How do you rate your own knowledge of investing?

Investor Knowledge	COURSE OR DEGREE	PROFESSIONAL EXPERIENCE	PERSONAL INVESTING	READING BOOKS, ARTICLES, WEBSITES
Where have you gained knowledge of investing? Tick all that apply.​

Investment History	NEVER / I DONT KNOW	LESS THAN 1 YEAR	1 – 3 YEARS	MORE THAN 3 YEARS
How long have you invested in bonds?
How long have you invested in equities?
How long have you invested in property?

Investment Sense	STRONGLY DISAGREE	DISAGREE	NEUTRAL	AGREE	STRONGLY AGREE
Diversifying your portfolio across many different assets helps to mitigate risk.
Past performance is not always a good indicator of future returns.
Investments may go down as well as up.
Good investing requires committing money for the long term.

Outputs 

The individual components are scored on a rating of Low, Medium and High and are then combined into an overall K&E score which is reported on a traffic light system of red, amber and green. 

Knowledge & Experience Overall

Red / Low	You are likely to have limited knowledge and experience of investing, and should invest at a reduced level of risk while you gain experience. Take care to ensure you explore and understand the investment recommendations presented.
Amber / Medium	You are likely to have moderate knowledge about investments and some experience of investing, and should consider investing at a reduced level of risk while you gain experience. Take time to ensure you explore and understand the investment recommendations presented.
Green / High	You are likely to have considerable knowledge and experience of investing, and should therefore invest at the suitable risk level. Despite this, please be mindful of the need to explore and understand the investment recommendations presented.

Investment History

Red / Low	You have relatively little experience with investing. Discussing any prior experiences may help identify your specific requirements and preferences.
Amber / Medium	You have some experience with investing. Discussing your prior experiences may help identify your specific requirements and preferences.
Green / High	You have ample experience with investing. Discussing your prior experiences may help identify your specific requirements and preferences.

Knowledge

Red / Low	You either consider yourself to have relatively limited knowledge of investing, or have few sources of investment expertise. Take care to understand and get comfortable with your investment recommendations.
Amber / Medium	You either consider yourself to have a basic working knowledge of investing, or have relatively limited sources of investment expertise. If an investment isn't familiar to you, it might be worth taking the time to ensure you properly understand the risks it entails.
Green / High	You consider yourself to have at least a reasonable knowledge of investing, and can back that up with multiple sources of expertise. Most investments will be familiar to you, but beware of any investing blind spots.

Investment Sense

Red / Low	Your investment principles score is low, which means that you have disagreed with some of the core investment principles, or you may have unrealistic expectations about risk and reward. You should seek further guidance and advice before investing.
Amber / Medium	Your investment principles score is medium, which means that you may not be confident about some of the core investment principles. You may require further guidance and advice before investing.
Green / High	Your investment principles score is high, which means that you understand the core investment principles. Nevertheless, it is important to explore the specific recommendations presented to you to make sure you understand them.

K&E – how it works

The scoring works as follows.

If Investor Knowledge is Low and Investment History is Low, then overall K&E is Red. 

If Investor Knowledge is Low and Investment History is Medium, then overall K&E is Amber. 

If Investor Knowledge is Low and Investment History is High, then overall K&E is Green. 

If Investor Knowledge is Medium and Investment History is Low, then overall K&E is Amber. 

If Investor Knowledge is Medium and Investment History is Medium, then overall K&E is Green. 

If Investor Knowledge is Medium and Investment History is High, then overall K&E is Green. 

If Investor Knowledge is High, and Investment History is Low, then overall K&E is Green.

If Investor Knowledge is High, and Investment History is Medium, then overall K&E is Green.

If Investor Knowledge is High, and Investment History is High, then overall K&E is Green.

If Investment Sense is Low, the overall K&E rating is reduced 1 level. For example, if Investor Knowledge is Medium, Investment History is High, and Investment Sense is Low, K&E would be reduced from Green to Amber.  

Where investors Knowledge and Experience is not green, advisers may wish to consider lowering investors overall Suitable Risk Level until sufficient knowledge has been acquired. 

Investor Compass will automatically lower investors Suitable Risk Level by one risk category for Amber levels of K&E and two categories for Red levels of K&E.  Advisers that are not using the financial circumstances assessment will need to manually consider lower levels of K&E when picking the Suitable Risk. 

Financial Circumstances

The Financial Circumstances Assessment calculates investors’ Risk Capacity – their financial ability to take risk. 

Risk Capacity compares the size of investors Total Net Wealthto the size of their Investible Assets and is used to determine whether to increase or reducethe Suitable Risk Level, relative to Risk Tolerance. 

RiskCapacity=TotalNetWealthInvestibleAssetsRisk Capacity=Total Net WealthInvestible Assets

If Total Net Wealth is large compared to Investible Assets then Risk Capacity is High and if Total Net Wealth is smaller than Investible Assets, Risk Capacity is Low. 

Total Net Wealth =Net Investible Assets +Net Non-investible Assets + Net Future Cashflows. 

Higher levels of risk capacity come from two sources – 1) positive Non Investible Assets (e.g. property less debts) and / or 2) positive Future Cashflows (e.g. income less expenditure). In other words the investor is in accumulation.

Lower levels of Risk Capacity occur where the investor’s debts are larger than their Non Investible Assets (i.e. they are in negative equity) and / or more likely when their expenditure exceeds their income (i.e. they are in drawdown). 

Investible Assets are those assets which the investor is prepared to invest at their Suitable Risk Level to meet future spending plans and goals and includes cash, investments and pensions. 

Some Investible Assets may be held elsewhereand Suitability Compass can work out the right level of risk to take with the Investible Assets you do have control over, to balance out the risk of externally-held portfolios.

Net Non-investible Assets are assets which the investor cannot invest in a diversified portfolio, such as properties, businesses assets, cars, art and other chattels. They should be adjusted to account for any debts 

When providing Non-investible Asset details, investors can indicate their willingness to sell them to fund spending. Higher levels of willingness will increase the Risk Capacity score. This is only an approximation, because it is very hard to put a number on willingness – and we believe it is better to be roughly right than precisely wrong.

Net Future Cashflows (income lessspending) are also considered as part of an investor’s overall wealth.This is related to the notion of “human capital”: young people have considerable expected future income, part of which will be used as contributions to their pensions. In the early stages of their careers, their pension pots are very small relative to their future size, and therefore should be invested at a high level of risk.

But because the future is highly uncertain, we incorporate a progressively stronger dampening effect on these cashflows. This is to ensure that Risk Capacity is considerably less influenced by income or expenditure anticipated more than five years hence.

When providing details of expected future income, investors can indicate roughly how certain they are that it will happen. Higher certainty of income increases Risk Capacity and higher certainty of spending decreases Risk Capacity 

Similarly, investors can specify how flexible they are about planned expenditures, and their importance.These approximations are used by Suitability Compass to reflect investor perceptions about future cashflows in their overall Risk Capacity, without attempting to be spuriously precise about every detail.

Simplified Risk Capacity

Instead of taking a holistic view of an investor’s wider wealth, Suitability Compass also offers a simplified version of Risk Capacity. This ignores Non-investible assets and extraneous cashflows and focuses solely on a single investment portfolio and any inflows to it / withdrawals from it.

Risk Capacity with pensions

If an investor has a pension portfolio and they are not old enough to access it, then it is worth considering the Risk Capacity of their aggregated investments and their non-pension investments distinctly.This is because a pension which an investor cannot yet access could, in some circumstances (i.e. when Risk Capacity of aggregated investments is low), act as a spur to take on undue risk. In such cases, we perform a separate calculation of Risk Capacity specifically for non-pension investments.

Inputs

The Financial Circumstances Assessment is a short financial fact find that collects information about investors’ Investible Assets, Non-investible Assets and Net Cash Flows. The information required will be very similar to data you are already collecting through your fact find so in most cases it is possible to populate this based on information collected elsewhere. In some cases it might be possible to use integrations to pull financial data from other systems to minimise double keying. 

Outputs

Risk Capacity is expressed verbally as either Low, Neutral, or High, depending on its calculated value.

Risk Capacity Value	Risk Capacity Label	Description
< 1	Low	​If Risk Capacity is less than 1, it means that an investor’s Overall Wealth is less than their Investible Assets. This can only happen if they have current liabilities and/or expected future net outflows. As such, they may not be able to afford to take the level of risk indicated by their Risk Tolerance, and should reduce it.
~ 1	Neutral	A calculated value of close to 1 means that an investor’s Overall Wealth is roughly equal to their Investible Assets.  In other words, they have neither excess Risk Capacity to afford an increase in risk beyond their Risk Tolerance, nor do they need to reduce risk below it.
> 1	High	If Risk Capacity is greater than 1, it means that an investor’s Overall Wealth is more than their Investible Assets. This means they have positive net non-investible assets and/or net future inflows. As such, they can afford to increase the risk of their Investible Assets beyond that indicated by their Risk Tolerance, if they are emotionally able to stomach it.

How it works

Risk Capacity is used to determine whether investors should increase or decrease risk relative to their Risk Tolerance.  If Risk Capacity is High it might be appropriate to increase the Suitable Risk Level and if Risk Capacity is Low it might be sensible to reduce the Suitable Risk Level, relative to Risk Capacity. 

Investor Compass will automatically consider Risk Capacity when calculating Investors Suitable Risk Level. Advisers who are not using the Financial Circumstances Assessment need to make their own assessment of Risk Capacity and manually select a Suitable Risk Level. 

Calculating the Suitable Risk Level is covered in more detail in the following section. 

Suitable Risk Level

The Suitable Risk Level is the amount of risk an investor should take with their Investible Assets. It is based upon the investor’s Risk Tolerance which is adjusted up or down based upon their Risk Capacity, Composure and Knowledge and Experience. 

Calculating the Suitable Risk Level

Investor Compass automatically calculates a Suitable Risk Level. But advisers that do not use the Financial Circumstances Assessment will need to manually select the Suitable Risk Level taking into consideration the following points.  

Combining Risk Tolerance and Risk Capacity

The starting point for calculating the Suitable Risk Level is the investor’s Risk Tolerance which is then adjusted up or down depending on their Risk Capacity.  Adjusting Risk Tolerance for Risk Capacity is simple - all we have to do is multiply the scores together.

For example, if a client’s Risk Tolerance is Medium on a five-point scale – i.e. 3 out of 5 – and they have a Risk Capacity score of 1.0, then their provisional Suitable Risk Level is:

[Equation]

If instead the Risk Capacity score was 1.3, then their Suitable Risk Level would be:

[Equation]

which would be rounded to 4, i.e. Medium-High risk.

This simple calculation works because, when Risk Capacity is high, the extra risk taken in the investment portfolio is diluted by the remaining, non-invested wealth. Conversely, when Risk Capacity is low, the investment portfolio takes on less risk, because it is effectively dialled-up relative to the investor’s overall wealth.In both cases, the risk of the investment portfolio is calibrated so that the risk of the investor’s overall wealth is in harmony with their Risk Tolerance.

The effect of Composure

The next step is to consider Composure. Even if an investor has ample capacity to increase the risk of their investment portfolio, it doesn’t mean they always should. Some people might not have the emotional reserves to stomach it.

So, any increases in Suitable Risk due to high Risk Capacity is diluted for investors with low Composure by 50%; for investors with Medium Composure it is diluted by 25%.

The effect of Knowledge & Experience

The effect of an investor’s K&E rating is as follows:

K&E rating	Effect on Suitable Risk Level
	Non-pension	Pension
High	-	-
Medium	Reduce by 1 level	-
Low	Reduce by 2 levels	Reduce by 1 level

Pension vs. non-pension risk

Suitability Compass calculates the Suitable Risk Levels for pensions and non-pension investment portfolios separately, reflecting the relatively “hands-off” nature of retirement pots.

For non-pension investments, we use the appropriate value of Risk Capacity – depending on whether it is prudent to exclude pension assets.For pension investments, we always use the Risk Capacity of aggregated investments, but apply a pension-specific adjustment for Knowledge & Experience.

This is summarised below:

Suitable Risk	Risk Tolerance	Risk Capacity	Knowledge & Experience
Non-pension portfolios	Unique value	Non-pension (if Risk Capacity of aggregated investments is low and pension is inaccessible); otherwise Risk Capacity of aggregated investments	Non-pension
Pension portfolios		Risk Capacity of aggregated investments	Pension

Separate Suitable Risk Levels for pension/non-pension assets are unavailable when using Simplified Risk Capacity.

Accounting for externally-held assets

Sometimes an investor will hold investible assets externally, which you may not have any control over. If these portfolios are not invested at their Suitable Risk Level, then it might be necessary to make a balancing adjustment to the recommended risk.

Suitability Compass will automatically work out how much risk investors should take with the portfolio under consideration so that their aggregated investment portfolio - including external assets – matches their Suitable Risk Level.

Investors can make this possible by providing high-level details of the nature of such portfolios (i.e. roughly how much is in cash, bonds, equities etc.) as part of the Financial Circumstances fact-find.

Accounting for externally-held assets is not applicable when using Simplified Risk Capacity.

Sustainability 

The Sustainable Investment Profiler measures investors preference for responsible investments and the extent to which they want to align their investible assets to positive environmental and social issues. 

Sustainability sits on top of risk profiling, so you shouldfirstly establish investors’Suitable Risk Level and then work out whether to aligninvestments to responsible solutions. 

Impact Desire

Impact desire measures investors’ strength of interest in responsible investing and is the starting point for determining how much to align investible assets to environmental and social good.

Inputs:

Here are the Impact Desire questions.

Questions	I would like to invest in organisations that actively pursue sustainability.​
	I would like to proactively seek investments in organizations that adopt progressive environment, social or governance practices.

Outputs:

The assessment places investors into three categories. 

Low	You have a comparatively low desire to seek investments that target sustainability and social good. You should focus your portfolio more on achieving your financial objectives, including sustainable investments wherever they may enhance returns.
Medium	You have a moderate desire to seek investments that target sustainability and social good. You should include sustainable investments in your portfolio wherever these are consistent with your financial objectives.
High	You have a high desire to seek investments that target sustainability and social good. You should proactively use your investments to pursue these aims alongside your financial objectives by using sustainable investments wherever possible.

How to use it

Investors with a High Impact Desire have a high interest in responsible investments and are more likely to want to invest a larger part of the wealth in sustainable solutions. Investors with Low Impact Desire are more likely to be focused on financial returns and may prefer to invest in more standard investment products. 

Impact Desire is combined with Impact Apprehension to produce an overall Including ESG in your investments score. This can be used as a guide to how much investors should align their portfolio to sustainable investments. 

We don’t as standard provide prescriptive rules about what percentage of the portfolio should be allocated to sustainable investments. This is because firms have different products and their own processes for mapping investors to sustainable solutions. But we can provide further guidance if it would be helpful. 

Impact Apprehension

We know from behavioural finance that unfamiliar investments are often perceived as more risky.  Impact Apprehension assesses whether investors areworried about sustainable investing because it is new or too complex. 

Inputs:

Here are the Impact Apprehension questions. 

Questions	Sustainable investing seems complex.
	I don't know enough about sustainable investing.

Outputs:

The assessment places investors into three categories. 

Low	You are relatively comfortable with the notion of sustainable investing. Weaving social and sustainable values into your portfolio does not put you off, even if it means adding novelty or additional complexity.
Medium	You are somewhat apprehensive about sustainable investing. The unfamiliarity, or additional complexity, of weaving social and sustainable values into your portfolio leaves you slightly daunted, but even so you are not completely put off.
High	You are quite apprehensive about sustainable investing. Weaving social and sustainable values into your portfolio represents unfamiliar territory, with which you are not yet fully comfortable. This doesn't mean you should avoid sustainable investing, but you would like more guidance on how this would work in practice.

How to use it

Investors with Low Impact Apprehension are likely to be comfortable with sustainable investments where as investors with High Impact Apprehension are likely to feel more concerned. 

Impact Apprehension is combined with Impact Desire to produce an overall ‘Including ESG in your investments’ score. Higher levels of Impact Apprehension will lower the overall recommended allocation to responsible investments and vice versa. 

Impact Trade-off

Impact Trade-off measures the extent to which investors prioritisedoing goodover financial returns.It can also be thought of in terms of ‘how green’ investors want their portfolio to be or how far they want to travel down the ‘impact spectrum’. 

Inputs

Here are the questions

Questions	I would accept a lower financial return if an investment had social or environmental benefits
	I wouldn’t mind locking up portions of my wealth for long periods if an investment had social or environmental benefits.
	I would be willing to take greater financial risk if an investment had social or environmental benefits.

Outputs:

The assessment places investors into three categories. 

Low	You have a low willingness to give up financial outcomes (e.g. take more risk, get lower returns, or reduce liquidity) to do more good with your investments. You may prefer to include sustainable or social investments only where they also contribute to your financial aims.
Medium	You may be willing to give up some limited financial outcomes (e.g. take more risk, get lower returns, or reduce liquidity) to do more good with your investments. You may be happy to consider sustainable investments to achieve improved sustainable and social outcomes even if they require you to make some financial trade-offs.
High	You have a high willingness to give up financial outcomes (e.g. take more risk, get lower returns, or reduce liquidity) to do more good with your investments. You would be happy to consider sustainable investments even where they require you to make significant financial trade-offs if you can achieve improved sustainable or social outcomes as a result.

How to use it

If Impact Desire and Impact Apprehension tell us how much to align investible assets to ESG, then Impact Trade-off helps to identify what type of Sustainable solution is most appropriate.

There are many different approaches to sustainable investing from more traditional investments that simply exclude the nasty stuff, through to solutions that actively seek to make a positive impact on the planet and society. Often the deeper you go the more investors have to make trade-offs like paying higher costs and investing in a smaller ‘investment universe’ which can lead to both over and under performance relative to more traditional approaches. 

Investors with High Impact Trade-off are more likely to be happy considering sustainable investments that require them to make significant financial trade-offs. 

Investors with Low Impact Trade-off have a low willingness to give up financial outcomes and may prefer to include sustainable investments only where they do not harm their financial prospects. ‘Lighter green’ funds which employ negative screening techniques or standard solutions with simple exclusionary approaches might be more suitable. 

Impact Apprehension

Impact Apprehension measures the extent to which an investor requires convincing to engage with responsible investing​.

Inputs

Here are the questions

Questions	I would need quantitative evidence to convince me an investment had a social or environmental impact.
	I would need real-life examples to convince me an investment had a social or environmental impact.

Outputs:

The assessment places investors into three categories. 

Low	You have a low need for evidence, which means that you may not need much evidence to trust that an investment will likely deliver a promised positive social impact. However, make sure you are comfortable that your investments are meeting your sustainability requirements.
Medium	You have a medium need for evidence, which means that you may need to see some, but not a great deal of, evidence that an investment will likely deliver a promised positive social impact. Make sure your investments are meeting your sustainability requirements​, but don't let this lead to inaction.
High	You have a high need for evidence, which means that you are keen to see strong evidence that an investment will likely deliver a promised positive social impact. Make sure your investments are meeting your sustainability requirements​, but don't let this become an excuse for inaction.

How to use it

Need for evidence helps with investor conversations and marketing by highlighting those individuals that need a little bit more information to convince them about the positive impact that their investments are making. 

Identifying suitable portfolios

What is investment risk?

A good risk measure should be meaningful to investors. We believe it should be:

• Forward-looking
• Long-term
• Focused on outcomes – in other words the destination, not the journey

Historical volatility may be ubiquitous in the investments industry, but it’s hardly relevant to most people. Worse, short-term volatility is unstable, so that the same portfolio ends up with a different risk rating over time, sometimes within months!

We therefore define investment risk as the standard deviation of projected long-term returns. By “long-term” we mean 10 years, and we present the figure annualised.Our definition of risk is most easily understood by looking at the chart below which is taken from Investor Compass. 

Here you can see the spread of returns from £100k invested into a medium risk portfolio after 10 years. The risk model projects forward many thousands of future paths based on 30 years of realmarket data. We use 9 asset classes as standard and the indices can be found hereWe then measure the spread of returns at 10 years (i.e. the standard deviation) and we annualise this number.

This definition of risk means that we have to project many possible future outcomes, rather than rely on a single set of historical returns. We describe our risk engine in a later section. In the chart above you can see just 5 of these thousands of projections which can be used to reinforce the fact that investing is never a smooth journey and there will be ups and downs along the way. 

Defining risk bands

For each level of risk, from Low to High, we work out how much risk would be acceptable to take. 

We do this by making some sensible assumptions about investments and how people feel about them – for example, what kind of returns are realistic for each level of risk? And how painful do investors in each risk level consider losses to be?

From these assumptions, we can work out how much risk is suitable for investors in each level – between the extremes of too little return, or too much risk.

Risk bands and metrics for 5risk categories

Risk band	Lower limit (%)	Mid-point (%)	Upper limit (%)
Low	1.7	3.3	5.0
Medium-Low	5.0	6.7	8.3
Medium	8.3	10.0	11.7
Medium-High	11.7	13.3	15.0
High	15.0	16.7	18.3

Risk bands for seven categories

Risk band	Lower limit (%)	Mid-point (%)	Upper limit (%)
Very Low	1.25	2.50	3.75
Low	3.75	5.00	6.25
Medium-Low	6.25	7.50	8.75
Medium	8.75	10.00	11.25
Medium-High	11.25	12.50	13.75
High	13.75	15.00	16.25
Very High	16.25	17.50	26.5

Measuring the risk of a portfolio

All that remains is to check that a portfolio’s risk is within the suitable range. 

To do this, we look at the mix of broad types of assets within the portfolio – for example, government and corporate bonds, developed and emerging market equities, property, and so on.

We then use a computer to simulate tens of thousands of possible future return paths for each asset class. Each return path is ten years long, to make them relevant to long-term investors.

In each scenario, we calculate the portfolio’s returns after ten years, and use these returns to measure how risky it is, making sure it’s within the acceptable range.

Risk model

Our model doesn’t make assumptions about the shape of every asset class’s distribution, nor their correlations with other assets. Instead, we remix historical index returns themselves.

Each simulation is generated by picking random months from history, and appending the returns for every asset class in each month as we go along. This captures a lot of the desired behavior - but not all.

So, to capture momentum and mean-reversion, we apply a chance of using the very next month in sequence. In this way, we preserve the unique characteristics of each asset class. The return paths are consistent with observed history, but not the same.

As a result, our simulations preserve the possibility of real-world extreme events, such as the Financial Crisis of 2008, but crucially don’t assume that the future will be a copy and paste of the past.

Sample Asset Allocations - Five categories

Each risk level has a set of StrategicAsset Allocations which sit close to the center of the risk band. 

Risk band	Cash (%)	Gov Bond (%)	Corp Bond (%)	Dev Equity (%)	EM Equity (%)
Low	35	40	10	15	0
Medium-Low	20	35	15	25	5
Medium	10	30	5	45	10
Medium-High	5	10	5	65	15
High	0	0	0	75	25

The portfolios are ‘suitably’ optimized meaning that they offer the highest expected returns for each risk band, whilst also aiming to have a sensible and coherent allocation to the different asset classes throughout the different Suitable Risk Levels.  More granular SAAs including property, commodities and hedge funds are available on request

Sample Asset Allocations - Seven categories

Risk band	Cash (%)	Gov Bond (%)	Corp Bond (%)	Dev Equity (%)	EM Equity (%)
Very Low	45	40	5	10	0
Low	30	35	10	25	0
Medium-Low	20	30	10	35	5
Medium	10	30	5	45	10
Medium-High	5	20	5	55	15
High	5	5	0	70	20
Very High	0	0	0	75	25

 

Indices

The risk model uses 30 years of historic market data and the underlying indices are used to model each asset class are included in the table below. 

Asset Class	Index
Cash	ICE BofA British Pound Deposit Offered Rate Constant Maturity (6 M)
Investment Grade Government Bonds	ICE BofA Global Government
Investment Grade Corporate Bonds	ICE BofA Global Corporate
High Yield Bonds	ICE BofA Global High Yield Constrained
Developed Equities	MSCI World
Emerging Equities	MSCI EM
Property	FTSE EPRA Nareit Global
Commodities	Bloomberg Commodity
Alternatives	HFRX Global Hedge Fund (GBP)

We have explored providing a more granular break down of alternatives but have concluded that the additional benefits of breaking hedge funds down further are minimal - at least where hedge funds are a relatively small part of a diversified portfolio.