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Managing investment risk in volatile markets:
Part one

For Professional Advisers only

Periods of market turmoil offer a chance to show clients how investment risk fluctuates, and to showcase the value of your advice…

Time in the market may beat timing the market, but time isn’t always on clients’ side.

Investors entering drawdown are robbed of time and, when markets are as turbulent as they have been, may be forced to reconsider their withdrawal strategies.

Market risk – the impact of a correction or bear market on clients’ plans – isn’t the same for every client. It changes over time, and this knowledge helps you shape your recommendations.

But there are risks to clients’ investments beyond market risk, and these vary too.

It is possible to plot how these risks rise and fall over an investment lifecycle for a typical client, and this can serve as a useful benchmark of why you make the recommendations you do.

A rocky time

The market turbulence triggered by the Coronavirus pandemic was not only remarkable for its scale, but for its speed.

Global stocks had the best and worst sessions in a decade on consecutive days. The S&P 500 was 30% lower in the middle of March but by 8 June was in positive territory for the year.

The disorder highlighted the many different investment risks that clients face, and why it is important to discuss them.

A (very) quick note on risk tolerance v capacity

Both risk tolerance and risk capacity are important in understanding the impact investment risks can have on clients, so it’s worth reiterating the key difference between them.

Put simply, risk tolerance is the amount of risk an individual is willing to take in the long term, while risk capacity refers to the amount of risk they can afford to take without jeopardising their financial goals.

Investment risk

Investment risks range from liquidity and longevity risks to black swan events such as the Coronavirus pandemic. They can overlap and interact. Unhelpfully, the same risks don’t always share the same name, depending on where you look.

Consider four of these risks and how they can impact clients.

Market risk is a broad term but refers to the risk of a loss because of a drop in the market price of shares. It covers market corrections, bear markets and, as we have experienced this year, the impact of black swan events. At retirement, market risk also encompasses sequence risk.

Longevity risk – you may use another term – is the risk to your clients of outliving their savings. Naturally, as savings are not typically needed until retirement, longevity risk increases as clients approach this point, particularly if they are not putting enough away.

Time horizons are key to recommending clients’ investment path. They refer to when clients will need to access their investments and applies to short-term goals, like saving for university fees, and longer-term objectives, like retirement. Time horizons do not affect an investor’s risk tolerance but are strongly linked to their risk capacity.

Event risk describes the impact of one-off ‘lifestyle’ events. Examples might be divorce, illness, or losing a job, each of which can alter an investment approach.

The impact of these investment risks on clients depends on a range of factors, including their immediate and future needs, life stage, and personality.

Segmentation

There are many ways to segment the investor market. Research suggests the most common is by assets but the fastest growing is by life stage. Either way, experiences, needs and risk tolerances can vary within each segment.

Take, for example, a five-step life stage model, beginning with starting wealth (0-18yrs), then building wealth (18-45), optimising wealth (45-60), retirement (60-75), and finally later life (75 and beyond).

One client’s journey through these phases might include a divorce, multiple career changes, and a market downturn at retirement (triggering the dreaded sequence risk) – all accompanied by a high risk tolerance throughout.

Another’s experience may include a large family, steady career, and friendly market performance approaching retirement, underscored by a low risk tolerance.

Therefore the impact of the investment risks – market risk, longevity risk, time horizon and event risk – as each of our clients move through these life stages would be different.

It is possible, however, to map the impact each of these risks might have for a typical client as they journey through life and towards retirement. Take a look at event risk:

We can do the same thing with longevity risk (click here for graph). This particular risk depends on how much clients are putting away, and on their health, but typically it will be higher during the optimising wealth stage than it is in later life, when there isn’t time to do much about it.

Similarly, market risk (click here for graph) rockets skywards as clients approach and enter retirement, then plummets in later life as any market exposure may be on behalf of grandchildren.

Finally, clients’ time horizons (click here for graph) obviously narrow as they approach their savings goals and, as with longevity risk, become somewhat irrelevant as they pass them. It illustrates why you encourage clients to act as early as possible, particularly when it comes to investing for a retirement income.

Visualising the impact of these risks on clients at different stages of their investment journey may prove helpful to clients, particularly at times of market turbulence.

The role of financial personality

Just as life stage, risk tolerance and investment objectives are important in determining the impact of our investment risks, so too is our emotional ability to take risk.

While all clients are on some level driven by their emotions, the differences between them are often astounding. Some clients will display impulsivity while others abhor it, while some will be composed during times of market stress just as others are straight on the phone at the first sign of a correction.

Overlaying financial personality on your understanding of the impact of investment risk on clients at different stages puts you in an informed position to help navigate clients through volatility.

Behavioural finance experts at Oxford Risk have identified a number of key dimensions of financial personality based on extensive research into investor psychology and financial wellbeing.

In our next article, we will examine how these dimensions fit into a comprehensive systematic approach to suitability across a client’s lifetime.

To find out more or to discuss any of the points raised in this article, contact your Account Manager on 0345 607 2013.

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This is part one of a four-part series on managing risk in volatile markets. If you want to receive further emails in this campaign, you can sign up below:

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Past performance is not necessarily a guide to future performance and the value of investments (and any income from them) can go down, so an investor may get back less than the amount invested.

About the author

Scott Sinclair, Content Strategy Manager, Embark Group

Scott Sinclair is a former financial journalist and editor who has spent the past five years creating engaging content for financial advisers, first with Zurich and then Embark Group. Scott was editor of Professional Adviser, part of Incisive Business Media, between 2012 and 2016.