What’s in a Rating?

In 2011 the FCA issued new guidance “Assessing suitability: establishing the risk a customer is willing and able to take and making a suitable investment selection”. This issue is particularly important when providing investment advice and risk profiling and should be taken into special consideration.

In order to be effective, risk profiling has to focus on both products (funds, model portfolios) and investors. When assessing the volatility of an individual investment instrument the focus is historical volatility.

At Russell Ivestments we go further and look at forward-looking assumptions (such as interest rates & inflation, equity & bond risk premia, dividends, default risk) for the following 10 year period. This is driven by our consulting heritage on multi-billion pound pension plans. When focusing on portfolios, correlation among the components of the portfolio plays a very significant role as it can have a remarkable effect on portfolio volatility and therefore on its risk.

Source: Russell Investments, 10 year outlooks as at 31 December 2014. These figures are prepared annually.

It is very important that both the investment and the investor’s risk profile are monitored on a regular basis to ensure ongoing matching between investor’s needs and financial instruments used to achieve those goals.

At Russell Investments we believe that a thorough understanding of our clients’ risk profiles is an essential step. We believe investing is a long-term journey and focusing on the long-term goals is paramount. However, in setting these goals it is essential to incorporate important factors related to the risk attitude, such as ability and willingness to take risk, as well as the tolerance for loss. The aim of the risk profiling activity is exactly to make sure that the risk attitude of all of clients is well understood and is consistent with their long term goals.

We identified 10 model portfolios that are built to provide our clients with the balance between risk and return with our model portfolio spanning from Secure (DT3) to Aggressive (DT7).  Each of these models specifies a target return that could be achieved in the next 10 years given the different levels of risk.

The below chart shows that our Balanced portfolio has an expected one year return of 5.4% and an expected one year volatility of 9.0%.  Two thirds of the time this means that investors can expect returns between -3.6% and 14.4% over one year. (Calculated by adding and subtracting the volatility expectation to the return expectation). We also show a reasonable potential forecast for the following 10 year period:

whats in a rating 2

Russell Investments, as at end of December 2014

Working on long-term goals as opposed to short-term view should help our clients to avoid one of the most common pitfalls in investing: being affected by the roller coaster of investor emotions, whereby investors may be tempted to chase rallying markets and to exit during downturns.

In any event, when giving financial advice to your clients it is advisable not to rely only on the risk profile rating, but also to give your professional opinion. Sometimes the outcome from the risk profile might not meet your client’s investment needs, especially in the case of over-reliance on synthetic indicators (such as risk ratings). Often, the best way forward for your advice is a more thorough and personalised assessment.