In the dark days pre-RDR, firms might ask whether a client was high, medium or low risk. If they gave the middle answer, the client would be prescribed a ‘balanced’ fund made up of a mix of asset types: cash, bonds, equities, and property.

As with any population, most people fall in the middle of the distribution and balanced products sold well. Insurers and banks created huge funds into which the majority of investors were advised or sold.

Over the last decade, the industry has professionalised. That said, the ‘balanced’ mentality still persists and it is dangerous, not least because there is no clear definition of what it is or what outcome you might expect from a ‘balanced’, multi-asset investment. The FCA references this in its Asset Management Market Study and is looking at how fund objectives can be improved for investors.

The Investment Association operates three categories which might tick the ‘balanced’ box: Mixed Investment 0-35% Shares, 20-60% Shares and 40-85% Shares. These are hardly clear definitions of the manufacturing process, let alone of the outcome that an investor might expect. It also means that the equity element, the riskiest part, can vary a lot within a category and indeed over time, changing the investment’s risk profile.

On a finer grained risk spectrum with 10 risk profiles, where one is cash and 10 is volatile emerging market equities, a ‘balanced’ portfolio might take you anywhere from a relatively cautious three out of 10, where only 25% is invested in equities, to seven out of 10 with 70% in equities.

Why does this matter? Well, in a prolonged bear market – a one in 20 series of events – a fund with a risk profile of three (following Dynamic Planner’s target asset allocation) might be expected to fall by around 18% over five years, whereas one with a risk profile of six might fall by 28%. Exceptional times for sure, but if the investor exits at the wrong time on a fund of £100,000 that is an additional loss of more than £10,000. If the client is retired, that is a 10% hit to their income. If they are working or looking to retire, that is another few years they need to remain doing so. It is also potential redress for the firm.

Equities are not the only asset class to involve risk, arguably all assets do, including cash where clients face the almost certain risk of losing money in relation to inflation over time.

More scientific analysis of a portfolio as part of a rigorous and consistent investment process, in which the investor is assessed on the same basis as the investment, will help you understand the nature of the risks clients face in combination.

If your firm still thinks of investors as ‘balanced’, here are three questions worth asking:

  1. Can we be more specific – on a scale of one to 10, where would each client fall?
  2. What is the value at risk these type of investments represent in a bear market and is this a good match for each client?
  3. Is it likely that the risk profile of the investment might change over time?

If you are not happy with the answers you reach, get in touch to discuss how Dynamic Planner’s Investment Process can help.

Ben Goss,

Dynamic Planner CEO