In the previous blog post Measuring and managing investment risk: Part 1, we looked at the popularity of volatility as a measure of risk and how FE Analytics can help in effectively monitoring it. Although volatility is a common measure of risk, it comes with certain inherent limitations when forecasting future performance or planning for worst case scenarios; hence Advisers ought to be mindful of an overreliance on volatility as the primary source of risk evaluation and management.
In part two of the series, we look beyond volatility at other crucial risk metrics and explore how FE Analytics can help Advisers adopt a more holistic approach to evaluating risk.
Drawdown risk: In the Perception of Risk Survey that we conducted in December 2016, over half of the respondent advisers (52.43%) prioritised Drawdown risk as ‘very important’ when advising clients on their investment portfolios. In other words, this is the maximum amount a fund would have lost if you bought at its peak and sold at the worst time – its maximum drawdown – can indicate the potential risk to holding a fund for all but the very long-term investor.
FE Analytics allows you to monitor this over an extended period by plotting the maximum drawdown of your fund (or a portfolio if your research so requires) on an intuitive bar chart. This is particularly crucial when you are thinking of a sell-off of an individual instrument.
Liquidity risk: Another risk to keep in mind in preparation for a sell-off in the short term is the liquidity risk of an instrument. The Market Movements report on FE Analytics can help you check stocks most bought, stocks most held, stocks most sold and look for recurring patterns.
Shortfall risk: Going back to the results of the FE Perception of risk survey, a significant number of respondents (51.47%) recognised the importance of considering shortfall risk when building client portfolios. However, many recognised the challenges involved in forecasting and exploring future risk with clients. The investment forecaster tool on FE Analytics can come in handy in such cases.
The investment forecaster tool can project the likely return of a pension pot (or other investment portfolio) across different time horizons and can help you to actively monitor any potential shortfall risk. Say for instance your client has a 10-year investment goal of £500,000, with the investment forecaster you can plot a proposed portfolio or the client’s existing portfolio to see the chances of achieving the goal. The bar charts show the highest to lowest possible returns of the portfolio over the 10-year period. In this case the shortfall risk is high and their approach will require adjustments.
Inflation risk: The eroding power of inflation doesn’t require much of an introduction. An inflation rate of just three percent a year can cut the value of income in half in real terms in less than 25 years and can have significant effect on the value of a portfolio if left unchecked without consistent rebalancing.
All graphs and tables on FE Analytics are automatically refreshed to reflect current value. This can help you consistently keep a close eye on portfolio valuations compared to UK inflation rates.
Sequencing risk: Sequencing risk is arguably the biggest threat to the health of an investor’s pension pot. The risk of needing to take money out of a portfolio when markets are down – thereby crystallising a loss. 35% of the respondents to the FE perception to risk survey said that sequencing risk was the most difficult metric to monitor.
The withdrawal feature on the investment forecaster tool is a good place to start analysis of the possible sequence risk.
It is important that volatility is never viewed in isolation as a single measure of risk. We hope this two-part series has given you comprehensive overview of how FE Analytics can help you monitor the wide variety of risk which may have a direct impact on your client's financial goals.
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