Risk Capacity

Of many things some few I shall explain, Teach thee to shun the dangers of the main, And how at length the promis’d shore to gain.

In early 1953 Thames breached flood defences and swept across the marshes of Belvedere and Erith (now London’s Thamesmead and Woolwich), also flooding houses and roads in Bexley, West Ham, and even Richmond. Plans for a flood barrier began soon after. The Thames Barrier opened in the 1980s, and since then it has been raised 180 times to stop tidal surges.

This is an excellent example of good risk management. London lies on a floodplain, and about forty five square miles of it, populated by more than a million people, are below the highest recorded water level. The area includes tens of tube stations, many miles of underground track, hospitals, power stations, as well as the Palace of Westminster, Tate Modern and the National Gallery. The cost of the barrier (£1.6bn in today’s money) is commensurate with the wealth it protects.

A sense proportion

The principle of proportionality is central to risk management. That’s why black swan events are such a pain in the arse: when the likelihood of occurrence is negligible and the impact both enormous and hard to quantify, how is one to come up with a proportionate cost-effective response? But I digress.

For risk management in personal finance two key principles apply:

  1. The risk you take as an investor has to be within your risk appetite; and
  2. Investment return has to adequately compensate you for that risk.

What constitutes a fair risk-adjusted return, and which asset classes offer such a return at any given time is subject to debate. People smarter than me are paid a shedload of money for their well publicised opinions on this matter, so I’ll be taking my tuppence elsewhere.

What’s my risk appetite?

That’s a good question, and the answer varies depending on how much money my portfolio happens to have lost recently. Or gained. Seeing red numbers on the screen tends to curb one’s enthusiasm for risk.

This is what my FinaMetrica risk score was at a time when my portfolio was less than £100,000 and included about £20,000 of unrealised gains. The result doesn’t seem unreasonable, and is comparable to the risk appetite score I was given by the IFA risk capacity survey at around the same time.

FinaMetrica Score

I don’t know this for a fact, but my guess is that, had I taken the same test with a portfolio of £500,000 that had just lost 30% of its value, my score might have been somewhat lower. Unless you’re a seasoned investor and can speak from experience, it’s hard to tell how well those test result will hold up under stress.

Bottom line: online testicles (is that what we call a test equivalent of a listicle, btw?) are fun to take, but a much better approach for beginners is to match the duration, set up a regular investment instruction by direct debit, and then never look at your investment account balance. Vanguard’s LifeStrategy funds are good for that sort of thing, they do the rebalancing for you.

… for shits and giggles…

According to risk appetite questionnaires, my capacity for taking on investment risk is decided by:

  1. How soon I’ll be needing the money. The longer the investment horizon, the longer I can afford to wait for any short-term losses to reverse, and hence the more risk I can take. I agree.
  2. Whether I enjoy a gamble. The larger my cojones, the less likely I am to panic and sell at the bottom of the market. That applies to volatile investments but not ones subject to a turkey distribution.
  3. My financial IQ. Presumably, when the urge to sell at the bottom of the market hits me, I can use my understanding of how markets and volatility work to talk myself out of it. I’m not sure about this one, doesn’t this (wrongly) imply that volatility is the only measure of risk?
  4. My income. The risk scoring people appear to suggest that the higher and more stable my income, the more risk I should be able to take. Sorry, but I have to call bullshit here. Because: buffering the day-to-day spending is the job for the Emergency Fund, not the long-term investment portfolio.
  5. My current net worth. And again, I fail to agree. It is my humble opinion that someone with a net worth of £600,000 who’s just lost £300,000 to a risky venture does not feel any better about the loss than someone with £60,000 who’s just lost £30,000.

And that’s why I’ve stopped wasting time on online risk appetite tests. This time, I feel, is better spent watching cat videos on YouTube;)