Attitude to risk and capacity for loss

Who wouldn’t want to get the best possible return on their investments? No-one! However, reward doesn’t come without risk.

As a rule of thumb, the riskier the investment the higher the potential return BUT investments can always go down as well as up and there is always the possibility that you may end up with less than you originally invested.

When your financial adviser asks you about your attitude to risk, your answer will probably be an emotional response guided by your character. Are you cautious by nature, or are you a gambler?

Attitude to risk is only half the equation and goes hand in hand with ‘capacity for loss’. Based on financial facts, not gut feel and instincts, your capacity for loss is a calculation based on the level of risk you are in a position to take.

In this article, our expert team of financial advisers at PIL Southampton looks at why attitude to risk and capacity for loss are equally important, and helps you to consider your decisions as, together, we weigh up the risk you can afford to take vs. the risk you are happy to take.

Attitude to risk 

Your ‘attitude to investment risk’ is an important part of any advice we provide to you.  It’s all about your feelings and beliefs and might not relate to your financial situation. Some investments have a fixed percentage return, like Gilts and Corporate Bonds. Inevitably, any return that is guaranteed will likely be lower than the potential returns available from fluctuating investments. 

Generally speaking, the higher the potential return, the higher the risk of loss.

Usually, equities (company shares) offer the greatest potential for capital growth, but they come with greater high risk. Risk and return typically reduces as you move into bonds and property. Property comes with liquidity risk; it can be quickly and easy sold and converted to cash. Cash offers the lowest risk and historically offers lower returns. 

There is no such thing as an investment which will give you above average returns without the acceptance of above average risk, but this does not guarantee high returns. 

It’s also important to note that, if you are too cautious, your attitude to risk might be so low that the value of your corresponding assets could decrease if they don’t keep up with inflation. The situation will likely be made worse by the various charges associated with managed investments. 

What is capacity for loss? 

Unlike attitude to risk, capacity for loss is based on financial facts, not feelings. It measures the extent that a financial loss would impact on your standard of living, and whether you will realistically have an opportunity to recover that loss in the future.

When we are scrutinising your capacity for loss, we’ll appraise losses in two categories – permanent and temporary. Temporary losses may be recoverable, like the markets taking a dip which might mean you having to tighten your belt until they (hopefully) recover.

An example of a permanent loss would be when an individual puts their full private pension fund into an unregulated investment that collapses. If they are close to or have reached retirement age with limited earning potential, this would be a permanent and irrevocable loss.

Factors that influence your capacity for loss 

Your capacity for loss will depend on anything that affects how well you will be able to absorb any investment loss and still live comfortably. For example, your level of assets, your expenditure commitments, and your age – which can determine how long you have to make good any losses.

Whereas your attitude to risk may change, as that is a personal decision, your capacity for loss is fixed by your financial circumstances. Once your capacity for loss is established, it would only change if your situation significantly changes, like being long-term unemployed or, conversely, coming into a large inheritance, for example.

A younger person with decades of earning potential and time to build a substantial pension pot is likely to have a higher than average capacity for loss, compared to someone who is close to retirement, doesn’t have much of a pension and still has a mortgage.

Assessing your capacity for loss

A crucial part of our process is to run through a Fact Find document with you. This covers a range of relevant areas that enables us to gather a full picture of your financial situation and your goals for the future.

As well as capturing details on your financial dependents, occupation, income, outgoings, assets and liabilities, emergency fund provision, existing policies like protection, pensions, ISAs and so on, the Fact Find includes a section on your attitude to risk and your investment aims. 

Depending on your answers, we will decide together what attitude to risk you have and then see if your capacity for loss matches that.

For example, if you think you have a high attitude to risk, but you don’t have any savings, we wouldn’t recommend a high-risk investment strategy as you wouldn’t have a savings buffer if the value of your investments dropped.

The scale is:

Low capacity of loss

You cannot afford for the proposed investment not to meet your objectives as failure to do so could have significant consequences on your standard of living. 

Medium capacity for loss

You may be able to afford slight under-performance of the investment, but it will cause you to adapt your standard of living.

High capacity for loss

You can afford to take the risks associated with your chosen attitude to risk and can withstand any under-performance.

We produce an annual client meeting report for those of our investment clients who have signed up for our ongoing service. As part of our review, we will go over your most recent factfind with you, to check whether your financial circumstances and plans have changed or need updating.

Cashflow Planning 

What is cashflow planning? 

This is software that allows us to present to you how long your assets will last under different scenarios and circumstances. This can be a means of measuring your capacity for loss and demonstrates how market changes can impact your standard of living and finances. Cashflow planning enables us to review your income, assets and expenditure. From that information, we can establish a target income.

Cashflow modelling scenario analysis 

It’s a useful exercise to input your individual information into a cashflow modelling tool, to review various outcomes and produce the best plan to suit you. You can watch PIL’s Cashflow modelling tool in action here.