7.2 Establishing an investor’s risk tolerance

Question 1

List 5 investments with capital risk

Answer 1

1. Equities can fall in value
2. Bonds can fall in value – even ones bought below par if they are traded prior to maturity
3. Gilts and bonds bought above par will certainly incur a capital loss if held to maturity
4. Property can fall in value
5. Most alternative assets can also fall in value

Question 2

Which 2 investments do not have the risk of a capital loss?

Answer 2

1. National Savings and Investments products are backed by the UK Government
2. UK gilts bought below par and held to maturity

Question 3

Do Bank and Building Society deposits have institution risk?

Answer 3

Yes, as illustrated by the Northern Rock crisis. Experience has shown that should a deposit institution get into financial difficulties and lose the confidence of its depositors, both the institution and the depositors may be at risk of capital losses.

Question 4

What is an invisible risk to cash deposits?

Answer 4

Inflation. If the cash returns are less than inflation, then the real value of the investment is falling over time.

Question 5

What is shortfall risk?

Answer 5

Shortfall risk is the risk that the investment return will literally fall short of the amount required for the investor to achieve their objectives.

Question 6

List 4 examples of shortfall risk

Answer 6

• Dividends from equities are not guaranteed as they depend on a company making profits and agreeing to pay some of them to shareholders
• Coupons from corporate bonds are also not guaranteed as they depend upon the issuer being able and willing to pay them – often referred to as issuer risk
• Variable rate cash deposits in Building Societies and Banks have income risk – that interest rates fall reducing the amount of interest payable
• Variable rate National Savings & Investments products also have income risk – such as the investment accounts, easy-access savings accounts, income bonds and direct ISAs It is also worth mentioning that it is the after tax income that is important for many investors.

Question 7

Explain Inflation risk?

Answer 7

Inflation erodes future values unless the investment earns a return in excess of inflation i.e. a real return. Investors who choose cash deposits as their type of medium- to long-term investment are most at risk from the effects of inflation.

Question 8

Name 2 investments which aim to provide protection against inflation.

Answer 8

1. Equities aim to provide a return in excess of inflation, but aiming is no guarantee to do this every year. Markets can of course fall as well as rise and be prone to periods of high volatility in both directions.
2. Index-linked gilts do provide some inflation protection.

Question 9

Explain deflation risk.

Answer 9

It is possible for a country to suffer from deflation risk i.e. falling prices. Japan has experienced a period of falling prices which carries the risk that people stop buying goods and services, waiting for prices to fall further. This fall in demand can be very damaging to an economy.

Question 10

Explain ‘interest rate risk’

Answer 10

Interest rate risk relates to the fact that the bank base rate is likely to change over time and ultimately feed through to the rates of interest paid on deposit accounts. The rate is set by the Monetary Policy Committee (MPC) of the Bank of England. Normally, the rate will be increased during times of inflation, but this is not always the case.

Question 11

Explain ‘currency risk’

Answer 11

`Individuals face the risk that their foreign currency investment depreciates relative to sterling when they convert their investment back to pounds.

Question 12

What risk do UK companies that import goods face?

Answer 12

UK companies that import goods face the risk that the sterling depreciates, making the cost of the imports more expensive.

Question 13

What is one way to hedge currency risk?

Answer 13

One way to hedge currency risk is with forward contracts. A forward contract is a type of derivative that can lock in a forward exchange rate in a foreign currency. Should the foreign currency depreciate, a gain will be made on the forward contract which will offset the loss on the foreign asset.

Question 14

What risk does hedging currency risk have in itself?

Answer 14

Hedging has a risk itself. ‘Basis risk’ is the risk that the gain from a hedge will not perfectly match the loss of the portfolio.

Question 15

Which investments have the potential for operational risk?

Answer 15

1. Deposits
2. Equities
3. Bonds
4. Property

Question 16

What are the 4 areas of operational risk?

Answer 16

1. People
2. Processes
3. Systems
4. External events

Question 17

Explain operational risk.

Answer 17

Mistakes by financial advisors, investment administrators, banks, buildings societies and investment companies do happen. There is the risk that due to such errors an investor is disadvantaged or, in the worst case scenario, is the victim of an investment fraud.

Question 18

Describe the process of financial advisors assessing risk.

Answer 18

Financial advisors will have an idea of the risk required to meet the investor’s return objective. However, they will also need to consider an investor’s risk capacity, as well as their willingness to take risk in establishing the client’s overall risk tolerance.It is very important to spend time getting this right at the start of the client/advisor relationship so that the most suitable advice can be given.

Question 19

List the two ways of determining a client’s attitude to risk.

Answer 19

1. Examining their existing investments
2. Asking specific questions

Question 20

List 7 factors that help determine a client’s ability to take risk

Answer 20

1. The client’s level of existing wealth
2. The client’s level of liquidity needed from the portfolio
3. The client’s time horizon
4. The client’s level of financial flexibility i.e. availability of other sources of income and capital
5. The client’s spending requirements
6. The client’s level of existing and future financial commitments
7. The client’s age and family situation i.e. they may have other urgent financial needs

Question 21

What is the problem with the approach many private investors take to investing?

Answer 21

As individuals we all have our own opinions as to what we want and what we do not want from our savings and investments, and we have our own understanding of investment risk. The trouble is that many private investors have no real knowledge of modern portfolio theory and are making investment decisions based upon their own perceptions rather than knowledge and experience.

Question 22

List 4 things that can be used to understand a client’s willingness to take risk.

Answer 22

1. The client’s views, feelings and preferences
2. The client’s answers to a risk and reward questionnaire
3. The client’s previous investment experience
4. Whether the client has taken risks in other areas of life e.g. running a business

Question 23

List the 3 risk categories used by Financial advisors.

Answer 23

1. Cautious
2. Balanced
3. Speculative

Question 24

List 3 risk tolerance categories used by financial advisors.

Answer 24

1. Below average
2. Average
3. Above average

Question 25

What are the three scenarios that can occur between the client’s willingness and ability to take risks?

Answer 25

If a client’s willingness to take risk matches their ability to take risk, then the advisor’s job is fairly straight- forward. But what if a client has a very high willingness to take risk, but has a low ability to take risk? Alternatively a client may have a very low willingness, but a much higher ability.

Question 26

What is the advisor’s duty?

Answer 26

It is up to the advisor to educate the client and ensure that the client receives the most suitable investment advice for their circumstances.

Question 27

Does the client have to take the advisor’s advice?

Answer 27

No! Ultimately the money belongs to the client and they can choose to accept or reject advice given.

Question 28

What is the next stage after assessing the client’s ability to take risk and what drives the next stage in the process?

Answer 28

It is often the client’s overall risk tolerance that drives the next stage in the process – asset allocation.

Question 29

What reduces portfolio risk?

Answer 29

It is well known that holding many assets in a portfolio reduces the overall portfolio risk compared to holding a small number of risky assets.

Question 30

How many holdings does a typical equity fund have?

Answer 30

A typical equity fund may have 80 or more individual holdings, with some funds having considerably more than this.

Question 31

What is the advantage of having many holdings in a portfolio?

Answer 31

If a particular company held in the portfolio falls on hard times and profits fall, it is only a small proportion of the overall portfolio. If this company was our only holding this could be disastrous.

Question 32

List 4 ways to diversify a portfolio.

Answer 32

1. Increasing the number of holdings
2. Investing in different asset classes e.g. equities, bonds, gilts, property, commodities
3. Investing in different industries
4. Investing in different countries

Question 33

What does modern portfolio theory allow?

Answer 33

Modern portfolio theory allows an investor to combine assets together, aiming to optimise the risk return trade-off i.e. to obtain as high a return as possible for a given level of risk.

Question 34

When we hold a diversified portfolio what happens to the levels of systematic and non-systematic risk?

Answer 34

• Diversification vastly reduces the level of non-systematic or specific risk within the portfolio
• Diversification does not take away the systematic risks of a portfolio

Question 35

ABC plc is one of 100 equities in a UK equity fund. ABC falls on hard times due to losing two important national contracts and also losing a number of key staff to a competitor. As a result ABC’s share price falls. What kind of impact does this have on the non-systemic risk?

Answer 35

Notice that the impact of the specific risk or non-systematic risk of ABC is much reduced as it is only one of 100 equity holdings. Although the drop in ABC’s share price cannot be avoided, the effect on the portfolio is small.

Question 36

What is another name for non-systemic risk?

Answer 36

Specific risk

Question 37

What does 3 risk types are classified as specific risk?

Answer 37

1. Industry risk
2. Management risk
3. Business risk

Question 38

Imagine if the UK economy began to suffer higher and higher levels of inflation. The Bank of England starts to put up interest rates to aim to keep inflation in check. Many UK firms will be affected by higher borrowing costs, perhaps putting off new projects and making cost cutbacks.

What kind of risk is this?

Would this affect UK equities?

What is the potential impact on the portfolio?

Answer 38

The majority of the UK equities are affected by this systematic risk of interest rates rising. The impact on the portfolio may be large.

Question 39

What is meant by the term ‘correlation’?

Answer 39

Correlation describes the extent that two assets move together.

Question 40

What is meant by ‘positive correlation’?

Answer 40

Positive correlation – assets generally move in the same direction

Question 41

What is meant by ‘negative correlation’?

Answer 41

Negative correlation – assets generally move in the opposite direction

Question 42

What is the relationship between the correlation between assets in a portfolio and its effect on the diversification benefits?

Answer 42

The lower the correlation between assets in a portfolio the greater are the diversification benefits.