This article offers a brief outline on the influences of Oxford Risk components on an individual’s Suitable Risk Level (SRL).
The SRL is the amount of risk an individual should take with their investment portfolio to ensure that the risk taken with their wealth is appropriate. The calculation to arrive at an investor’s SRL is comprised of the four components below:
- Risk Tolerance
- Risk Capacity
- Knowledge & Experience
The SRL is expressed on a 7-category scale, from very low to very high, but behind the scenes the calculations use a continuous spectrum of numbers. If a client scores below 1 or above 7, the output will display as a 1 or a 7, respectively, even though the true value could be outside of this range. If a client’s score is not a whole number (e.g. 4.53), it will get rounded to the nearest category (e.g. 5).
Step 1: Risk Tolerance
An investor’s Risk Tolerance reflects their willingness to accept the possibility of lower long-term outcomes for a greater chance of increased long-term returns. The SRL starts life as Risk Tolerance. The final SRL figure reflects the appropriate level of risk for the investible portion of their wealth such that the risk taken over their entire wealth is in tune with their Risk Tolerance.
The Risk Tolerance element of the Investor Compass comprises questions which collectively enable the placement of each individual on a psychometric scale, relative to the baseline population. These questions are scored on a Likert scale, from “Strongly Disagree” to “Strongly Agree”, and bucketed into a 7 category scale (Very Low to Very High) in such a way as to maintain a normal distribution.
Step 2: the effect of Risk Capacity
Risk Tolerance identifies the appropriate level of risk for an investor’s entire wealth, and Risk Capacity determines how large investible assets are relative to total wealth. Investors who are putting only a small portion of their overall wealth at risk (for example, people with ‘human capital’ arising from high future income and savings) will have the capacity to take more risk with their investible assets.
Risk Capacity therefore reflects an investor’s financial ability to take risk with their investible wealth given their current circumstances and future aspirations. It can be seen as an investor’s reliance on their investments to fund future (particularly near-term) financial commitments, and therefore their ability to take risk with their investible wealth without jeopardising these commitments.
Risk Capacity is calculated by looking at a client’s assets (cash accounts, investments, properties, etc.), liabilities (mortgages, credit cards, etc.) and a present value estimate of their future income and future expenditure. Intuitively, if an investor has an extensive portfolio of property and investments, they are more able to accept risky propositions than someone with a smaller overall wealth.
After assessing Risk Tolerance and Risk Capacity, it is straightforward to calculate the SRL: we simply multiply the two scores together. This calculation works because when Risk Capacity is high, the extra risk taken in the investible assets is balanced by the non-investible assets and/or future wealth.
Conversely, when Risk Capacity is low, the investible assets take on less risk, because overall wealth position is effectively already at risk.
In both cases, the risk of the investment portfolio is calibrated so that the risk of the investor’s overall wealth is aligned to their Risk Tolerance.
Step 3: the Composure dampener
Some investors may not have the emotional reserves to weather short term market volatility. Even if they have ample capacity to increase the risk of their investment portfolio, it doesn’t mean they always should. To account for this, the SRL is dampened according to the degree of Composure that an investor displays. Composure is measured using simple Likert scale questions, similar to the Risk Tolerance questions.
To account for investors with low Composure, the SRL gets reduced or ‘dampened’ by a variable amount, determined by the Composure score. For example, a client with very low Composure may have their SRL reduced by 25% to safeguard them against being exposed to an uncomfortable amount of volatility.
For some clients with low Composure but high Risk Capacity, this dampened SRL may still be too high. The tool automatically adjusts for this in two ways:
- by ‘pulling back’ the SRL towards the Risk Tolerance score, and
- by placing a ‘cap’ on how high the SRL can be elevated by Risk Capacity.
The size of each of these adjustments is relative to the investor’s Composure score; for example, an investor in the 25th percentile of Composure would receive larger adjustments than an investor in the 50th percentile.
Step 4: the Knowledge and Experience dampener
Knowledge and Experience (K&E) is a key inclusion when determining SRL as it allows advisers to ensure that their client can realistically know what they’re investing in.
If an investor has good K&E, there is no need to adjust the SRL: the investor is fully capable of making investment decisions.
If an investor has moderate K&E, it makes sense to reduce the SRL until they have gained more experience. We apply a dampener to reduce the SRL by 12.5%, or to within 2 levels above risk tolerance (whichever is lower).
If an investor has low K&E, we apply a dampener to reduce the SRL by 25%, or to within 1 level above risk tolerance (whichever is lower).
For investors who have very high risk capacity, these adjustments may not be strong enough to bring the risk level down to a suitable level. Therefore, we also cap the maximum risk level for investors who do not have good K&E. For moderate K&E, the maximum risk level they can be recommended is two levels above their risk tolerance, or risk level 5 – whichever is lower. For low K&E, the maximum risk level is one level above risk tolerance, or risk level 4 – whichever is lower.