If I was a financial adviser I would ignore the risk rating assigned to me based on the risk assessment I do!
Anyone who has a pension, a medium to long term savings plan or lump sum investment will have undergone a risk profiling exercise which will you identify your tolerance for risk. This will have matched your tolerance for risk to your appetite for growth and given you a score, typically from 1 to 7.
Your money will then have been invested accordingly.
But I have problem with this approach.
My risk appetite changes dramatically depending on what I am trying to do.
I know that if I saving for retirement that I am prepared to take a very high level of risk. But if I am saving for kids education in 5 or 6 years from now that I would only take a medium amount of risk really. Furthermore if was savings to build up an emergency fund which could be needed tomorrow I am prepared to take no risk at all and into the bank it goes, however if I have a decent emergency fund built up already and I want to earn a little growth in the short term then I will take risk even though I might use the money next month or next year.
My point is just this. I believe the risk rating system is flawed. Clients who were prepared to take medium amount of risk and were invested in medium risked funds in 2008 lost 45% of their money. Not exactly what they signed up for. This fund, based on the risk measures used would then have been classified as high risk, but crucially once the horse had bolted.
In the financial services industry we typically use a scale called the ESMA scale which is based on expected volatility but again it has it flaws. ESMA 1, 2 and 3 span expected movements in value between 0% and 5%. So 3 entire bands cover only 5% expected movements. ESMA 4 spans 5% – 10%. So the next band then covers 5% too. I can live with ESMA 5 as it is again a 5% band ranging from 10% – 15%, but ESMA 6 then doubles its range!
Anyway, I know there is no perfect measure but I believe in 2 things.
1. Measure your appetite for risk based on the event too, not just your risk profile on the day. If you are making a decision about retirement, perhaps you might be a 6. If you saving for an event 5 years away perhaps you might be a 3. It seems wrong to simply pigeon hole all your investments into one when they are entirely different needs with entirely different time frames.
2. A sensible approach seems to be to give clients a greater understanding on the investment itself. We tell our client’s what’s under the bonnet.
No system is perfect and I am not suggesting I have all the answers on this one but I think it’s flawed to suggest that a client should never invest in something that has risk attached if it’s for less than 5 years. Nor do I think that it makes a huge amount of sense to invest a client’s pension assets in the same risk category as their 5 year savings.
Think a little bit about this the next time you are reviewing your investments, savings and your retirement fund selection.
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