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Risk: A key component to defining a goal

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Risk management, capital protection and “certainty around what will happen to my capital” have become buzz phrases given the impact that the Covid-19 pandemic had on financial markets. After an extended period of positive market returns prior to the pandemic and then experiencing the pandemic and the extreme downside volatility that investment markets can bring, investors are increasingly highlighting what risk means to them – either by voicing it verbally or through their decisions on what they do with their capital and investments.

Stay Invested

In an uncertain world, it is key to plan and sculpt that ‘optimal’ client-focused investment portfolio to make sure you help them achieve their personal financial goals. The most important aspect in understanding clients’ needs and to keep them invested, is to ultimately understand their risk profiles. 

Staying invested often sounds easier than it really is, due to our inherent desire to control our investment outcome. The problem is often that when the focus becomes too short-term, risk is not clearly defined or understood, we get swayed by our emotions; making it an increasingly difficult task to stick to an investment strategy that is designed for the longer term. As fund managers and investment advisers, we have a responsibility to steer clients toward their personal realistic investment goals.

Clients’ goals or investment objectives cannot be formulated if the return requirements and the risk constraints are not properly understood. Most clients do not have an idea of what their risk profiles are. They typically understand and know what they would like to achieve, but hardly ever understand what it means from a risk perspective to deliver on the goal.

Calculating Risk

In the traditional sense of the word, risk in investments is measured in a mathematical sense based on a historical profile. There are various different ways of calculating risk measures and all these risk measures have a place in investments if understood, interpreted and applied correctly. But risk is not equal for all. 

For most investors with a goal in mind, risk is the probability of not delivering on the goal, the erosion of the purchasing power of their capital over time, or perhaps the loss of capital, or a combination of these. All these measures are tangible and well understood.

A client risk profile is usually defined on a behavioural basis along three different dimensions – the willingness to take risk, the ability to take risk, and the need to accept risk. By understanding the true client risk profile and linking that to the investment goal, a more informed investment portfolio can be designed, monitored and steered along the path to successful delivery on the objective with a high degree of certainty.

Managing Misconceptions

Misunderstandings about what risk means are very common, and they are extremely dangerous. Risk is not just one-sided as not taking risk can be risky. 

We need to strive to understand the true risk profile of clients, build these risk profiles into the design and construction of the client portfolio, understand the sensitivities to real-world unforeseen risks and monitor and manage the risk relative to the desired outcome. This minimises the probability of a shortfall relative to the client goal. 

With so many things in life out of our control, it can bring comfort to focus on things that we can control. Risk is one of the few things that can be controlled when it comes to investing and it just may be one of the most important if properly understood and defined. Focusing on a disciplined client focused investment strategy rather than the whims of the market is a key component of helping your clients achieve their personal financial goals.