Financial circumstances and goals: Holistic vs. Simplified Assessments – Oxford Risk

Instead of taking a holistic view of an investor’s wider wealth, Investor 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.

Contents

Determining a suitable level of risk

The suitable level of risk for an investor to take is influenced by four key factors.

Risk Tolerance is an investor’s stable, long-term, reasoned willingness to accept the possibility of lower long-term outcomes for a greater chance of higher long-term returns.
Risk Capacity reflects an investor’s ability to take risk with their investible wealth given their current circumstances and future aspirations.
Composure is a measure of an investor's tendency to become anxious during their investment journey, which can influence their ability to stick to a plan.
And finally, Knowledge and Experience reveals whether an investor is in a position to realistically know what they’re investing in.

This document outlines two approaches for calculating Risk Capacity: the holistic assessment of financial circumstances and goals, which is the gold standard; and the simplified assessment, which makes a modest trade-off of accuracy in favour of speed.

Holistic Financial Circumstances

Accounting for what an investor owns (or will own) is fundamental to calculating what level of risk they should take. Risk Capacity 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 overall wealth without jeopardising these commitments. If future expenditure were covered by a guaranteed income – if investments could dwindle to nothing without any effect on one’s standard of living – then the only constraint on the risk taken with one’s investments would be psychological.

Risk Capacity determines an investor’s Suitable Risk Level (SRL) for their investible assets. It does so in such a way as to ensure the investor’s holistic wealth position is exposed to the level of risk indicated by their Risk Tolerance.

Risk Capacity and investible assets

Investible assets are the assets to which we want to apply a Suitable Risk Level. They are also a proportion of the resources that determine the Suitable Risk Level in the first place, as a component of our financial ability to take investment risk.

Cash accounts – including current accounts, easy-access or term savings accounts, cash ISAs, etc.
Investment accounts – including stocks and shares ISAs, and general investment accounts
Pension accounts – including workplace pensions and SIPPs

The Suitable Risk Level applies to an investor as a whole, accounting for not only their Financial Personality, but also their Financial Circumstances. A Suitable Risk Level can be seen as a ‘risk budget’ from which an investor ‘spends’ some risk with their investible assets. Spend too much, and you get into trouble. Spend too little, and you’re not making the most of your potential.

Risk Tolerance identifies the appropriate level of risk for an investor’s holistic wealth position, thus we need a measure of Risk Capacity to determine how large their investible assets are relative to their total wealth. Investors putting only a small portion of their wealth at risk (for example, if much of their wealth is in their human capital because they have high future income) will have the capacity to take more risk with their investible assets.

Risk Capacity determines the investible portion of total wealth so that we know what risk to invest at to adjust for the investor’s total circumstances.

Net non-investible assets: What else have I got?

Other assets that affect an investor’s reliance on their investible assets include:

Non-investible assets – Properties, vehicles, collectibles, business assets, and other “hard assets” increase an investor’s holistic wealth position.
Liabilities – Debts secured against these assets and significant unsecured debts decrease an investor’s holistic wealth position.

The values of non-investible assets are dampened in the risk model, to adjust the input amounts to ‘cash equivalent’ amounts. This process accounts for valuation uncertainty, liquidity, and emotional attachment, all of which could significantly reduce an asset’s value for Risk Capacity purposes relative to its nominal balance-sheet value.

Net future assets: What are my expected future cash flows?

Expected financial flows that affect an investor’s reliance on their investible assets include:

Future assets – Expected income and inheritances will increase holistic wealth position.

Future liabilities – Expected spending, gifts away, and other high-priority goals will decrease holistic wealth position.

All future cash flows are subject to dampeners to reflect their inherent uncertainty, their priority/importance, and the flexibility of spending plans (e.g. to change the amount, postpone payment, or cancel it altogether). Non-negotiable, time-limited goals where there is no control over the cost reduce Risk Capacity, while the ability to change plans increases it.

Future spending is discounted in the risk model such that we ensure a balance between protecting nearer spending needs and remaining invested to build wealth to fund future spending needs. Distant spending should not be protected by sitting on cash; the investor is better served by remaining invested and reducing risk only as these goals come nearer.

The Risk Capacity tool does this by reducing risk only insofar as the time horizon (and certainty and priority) of future goals requires it, and dynamically adjusting this profile as goals and spending come closer.

For example, school fees are inflexible because they either happen at a set time or not at all, and the cost is fixed. Aspirational purchases that one could do without, or that one could substitute a less-expensive alternative are much more flexible.

High-priority goals are included in the calculation of Risk Capacity. Lower-priority or more distant goals are not. This is because any goals that aren’t high priority are essentially already contingent on the realised investment outcomes: if times are hard, and the investment portfolio has performed badly such goals are likely to be postponed, shrunk, or eliminated.

Dealing with limited information

Often, clients cannot (or will not) share all their financial information, which can potentially skew the estimate of Risk Capacity and therefore reduce the ability to provide investors with the right level of risk.

The Risk Capacity calculation is designed to cope with limited information, whether because the adviser manages only one of multiple accounts owned by an investor, or because the investor refuses to disclose information. The tool functions from a simple base of information, which can be strengthened by each additional detail. For example:

Net investible assets – These are ideally recorded account-by-account and including asset allocations, but it is possible to enter less granular detail and still arrive at a sound answer.
Net non-investible assets – These are ideally recorded per item (or by category for very wealthy clients where individual items are a small portion of total wealth) such as non-investment property, vehicles, collectibles, but it is possible to enter less granular detail and still arrive at an answer.
Net future assets – Current and future income streams and expected lump sums should be recorded. These are all subject to levels of certainty (e.g. a freelancer’s income is less certain than someone with a steady job). Lack of information of future income naturally errs on the side of caution, tending to push Risk Capacity down. However, leaving out future expenditure, particularly high priority near-term spending, might result in Risk Capacity being unreasonably high and so investors should be encouraged to take care not to under-represent spending.

Simplified Financial Circumstances

Given that the risk capacity algorithm has been designed to cope with limited information, it is also possible to apply the same core approach to a streamlined set of inputs. For example, a simplified advice proposition might aim to provide portfolio recommendations for a single account – which may or may not have a goal connected to it – and this offering would require fewer questions overall.

Asking fewer questions reduces the accuracy of the suitable risk level calculation; however, provided the simplified questionnaire is designed correctly, this risk can be controlled such that the suitable risk level could be lower than the ideal level, but will never be higher. This approach allows firms to adopt act conservatively with clients for whom they do not have complete information.

Financial data	Holistic	Simplified
Cash Accounts	Ask about as many accounts as needed to get full picture	Not asked
Investment accounts	Ask about as many accounts as needed to get full picture	Ask only about the investment account being opened (i.e. initial investment)
Pension accounts	Ask about as many accounts as needed to get full picture	Not asked (unless the account being opened is a SIPP)
Income	Ask about all sources of income	Ask questions only for current ongoing household income, and anticipated end date (e.g. retirement)
Expenditure	Ask about all expenditure, both ongoing and future spending plans	Ask questions only for current ongoing household expenditure and any spending plans intended to be funded by specific account in question
Non-investible assets	Ask about all significant asset, and liabilities against these assets	Not asked
Debts	Ask about any significant debts	Ask if there are any significant debts (yes or no)

Key considerations

The simplified financial circumstances questionnaire works best when the total investible assets are very small, such as when the investor has just started saving, they are saving regularly, and the pot is very small; and/or when the account in question is a small percentage of overall investible wealth (ca. <15%)

Moreover, it is important that the client has passed various “safety checks”, including:

Their ongoing income is greater than ongoing expenses
They have an adequate savings buffer (e.g. 3 months’ expenditure) held in cash
There are no significant debts (e.g. a high LTV mortgage or large unsecured loans)
They are not taking high investment risks in other accounts (including externally held assets)

If any of these safety checks are not met, it may be necessary to gather additional information on those specific elements not met. For example, if the client indicates that they have significant debts, presenting the non-investible asset and liability questions from the holistic questionnaire can establish how – or whether it is appropriate – to proceed with this client.

Calculating risk capacity

Risk Capacity measures the importance of investible assets for funding spending/goals relative to everything else an investor owns or is likely to own in future. Though there is a lot of detail unpinning it, Risk Capacity is essentially encapsulated in a single ratio of the holistic wealth position (including future human capital and goals; and non-investible assets) to current investible assets.

To calculate Risk Capacity, we take the sum value of the investible assets (i.e. cash, investment and pension accounts). We then calculate the holistic wealth position by summing the investible assets with the current cash-equivalent values of the client’s income, expenditure, non-investible assets, and liabilities. The ratio of the investible assets and the holistic wealth position represents the Risk Capacity score.

There is a key dividing line around a Risk Capacity of 1:

Risk Capacity greater than 1 indicates a low reliance on investments for funding future expenditure, that is the investible assets are smaller than the cash equivalent of the holistic wealth position.
Risk Capacity less than 1 indicates a high reliance on investments for funding future expenditure, that is the investible assets are larger than the holistic wealth position cash equivalent. This scenario usually occurs for investors in, or entering, drawdown, who have future cash flows to fund from their investments.

A Risk Capacity score greater than 1 can increase the suitable risk level for the investible assets, whereas a score less than 1 can reduce it – potentially so far as to suggest that an investor cannot afford to take investment risk