Our approach to investment management
Before diving into how we approach our investment conversations with clients I should explain two fundamental concepts which commonly influence and underpin our investment decisions.
These are risk tolerance and capacity for loss. While often used interchangeably, the terms hold distinct meanings. Although they’re both important, focusing too much on a person’s risk tolerance, rather than their capacity for loss can lead to sub-optimal investment decisions.
Risk tolerance vs. capacity for loss
Risk tolerance generally refers to an investor’s psychological willingness to withstand fluctuations in the value of their investments. It reflects the individual’s comfort level with volatility and the possibility of losing money in pursuit of potential returns.
- Risk tolerance is subjective and varies from person to person based on factors such as personality, financial goals, investment experience, and time horizon. Investors with a higher risk tolerance are more inclined to accept greater volatility in pursuit of potentially higher returns, whereas those with lower risk tolerance prioritise capital preservation and are more averse to market fluctuations.
- Capacity for loss is an objective assessment of an investor’s financial ability to absorb potential losses without jeopardising their financial well-being or ability to meet essential financial goals. It takes into account factors such as income, expenses, assets, liabilities, and time horizon.
While risk tolerance deals with emotions and attitudes towards volatility, capacity for loss focuses on financial realities and the ability to withstand adverse outcomes without significant negative consequences. At Yellowtail we put more weight on a person’s ‘capacity for loss’ alongside their need to take investment risks over their ‘emotional’ reaction to volatility.
Risk profiling
In order to assess someone’s risk tolerance, many advisers will use risk profiling questionnaires. These comprise a set of tick box questions to establish your attitude to risk. Questions will be based around age, major life changes, income, investment comfort level and how you might handle potential losses. On completion you’ll receive a score which indicates where you are on the risk tolerance scale. In our opinion they tend to be compliance driven and designed to protect the advisory firm should a client be unhappy when markets fall and there is a loss.
We discuss risk profiling in one of our Century Plan podcasts that you can listen to below.
The problem with risk profiling questionnaires
It is important that some form of risk assessment takes place, but we don’t believe it should be in a form of a questionnaire built along something akin to a hospital pain scale: no pain is green and extreme pain is red. The questionnaires suggest no pain could be cash, and real pain could be investing in the stock market, where things go up or down.
It means we’re framing investments in shares and equities as somehow being painful.
But what we are really referring to is volatility. And I find that most people, if told they’ve got to take a little bit of pain, to get the returns that you want, will say, well, if I’ve got to take some pain, I can maybe withstand something in the yellow to orange mid-range.
Risk profiling tools therefore tend to drive people to take the middle path, because we’re talking to people about pain. And for most people, I think that’s a sub optimal place to be. It avoids talking to people about what their money needs to do for them.
When it comes to investing most people would like to see a straight line, without the fluctuations. But when asked what sort of returns they would like, and if we start doing some cash flow modelling about what their money needs to do, it generally leads to them needing to accept a more volatile path. But here’s the important part; volatility is just one aspect and measure of risk. There are many other types of risks to be aware of when making investment decisions and I have outlined some of these below:
Types of investment risk
- Inflation risk refers to the possibility that the rate of inflation will erode the real value of an investment over time. Investments that fail to outpace inflation may result in a loss of purchasing power, diminishing the investor’s ability to maintain their standard of living. I’m going to mention tax here too, because we really need to be measuring the post tax returns against inflation.
- Credit risk arises when issuers of fixed-income securities (commonly referred to as bonds) fail to make timely interest or principal payments. This risk is more pronounced in lower-quality bonds or issuers with weaker financial profiles. Diversification and credit analysis are essential in managing credit risk exposure.
- Concentration risk stems from having a significant portion of an investment portfolio allocated to a single asset class, sector, or individual investment. While concentrated positions can lead to outsized returns, they also expose investors to heightened volatility and potential losses if the underlying asset performs poorly. We often see this with people who have a large holding in their employer’s company, through share options etc.
- Foreign exchange risk, or currency risk, arises from fluctuations in exchange rates that can affect the value of investments denominated in foreign currencies. Investors holding foreign assets are exposed to potential gains or losses resulting from changes in currency values relative to their home currency.
- Horizon risk refers to the possibility that investment returns may vary based on the timing of market movements relative to an investor’s time horizon. Short-term market fluctuations may have a more significant impact on investors with imminent financial goals compared to those with longer investment horizons.
- Market risk encompasses the broad factors that affect the overall performance of financial markets, such as economic conditions, geopolitical events, and interest rate movements. Market risk can’t be eliminated through diversification in that market but can be managed through different asset allocation and risk mitigation strategies – for example holding a portfolio comprising equities and bonds.
- Longevity risk arises from the uncertainty surrounding how long an individual will live and the adequacy of their financial resources to support them throughout their lifetime. Outliving one’s assets can have significant financial implications, particularly in retirement, underscoring the importance of prudent financial planning and risk management.
The Financial Conduct Authority does not require advisers to use risk profiling questionnaires. The requirement is that an adviser must know their client (KYC). We must know enough about them to ensure that whatever investments we recommend are appropriate for them. And that might not have relatively little to do with their emotional response to market volatility if they need to take higher risk in order to achieve their objectives. In our experience, understanding the bigger picture and how investments fit in tends to reduce the emotional impact of market volatility.
Our job, as financial planners, is to inform, and to show why this is going to happen. We don’t use risk profiling questionnaires at Yellowtail because it leads to people not taking enough investment risk. It’s not an easy conversation, particularly if someone feels they are a balanced profile investor. But the real risk is that a balanced portfolio won’t get you to where you want to be. If your money will run out by the time you’re 80 and you live until you’re 90 (or beyond) that’s going to be a more difficult conversation!
We need to look beyond your initial comfort zone and show you that you can afford to take that risk and help you get comfortable taking that risk. And this is why our philosophy is centred around evidence-based investing.
Evidence based investing
Evidence-based investing simply means taking investment decisions based on empirical evidence, academic research, and historical data rather than speculation or market timing.
This approach prioritises factors such as asset allocation, diversification, low-cost investing, and disciplined rebalancing over attempts to outguess the market or chase short-term trends. And the evidence does show that in the overwhelming majority of times this evidence-based approach wins out.
By adhering to evidence-based principles, investors can benefit from the long-term advantages of capital markets while minimising the impact of emotional biases and market noise.
Unfortunately, the financial pages of weekend papers routinely carry advertisements and articles referring to successful funds and fund managers. And in the short term, maybe over a year or so, many funds do post market-beating returns. But as you keep expanding the timeline, from one year, to three years, to ten years and so on, the number of funds that consistently outperform the market becomes very small, assuming they haven’t folded in the meantime!
There is however a constant and consistent relationship between a fund’s performance and it’s cost. Low-cost funds by and large outperform high-cost over time. There is probably no better example of this than comparing a low-cost index-tracker fund to the high-cost bastion of intellectual investing expertise, the hedge fund. It’s worth looking up the wager made between Warren Buffett and the hedge fund industry where he wagered $1 Million that over a 10 year period the S&P500 (the US equivalent of our FT-SE100) would beat the Hedge Fund. (Long story short, only one Hedge Fund Manager was prepared to take on the wager, and shortly before the 10 years were up, they conceded defeat).
When designing portfolios for our clients we avoid fads and speculation, choosing instead to follow the evidence, control costs, and stick to strategies that we can test and replicate in the real world.
