Authorities making a mess of measuring risk

by John Fitzsimons on 02 August 2011  |  0 comments
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Guest blogger John Lawson of Standard Life looks at the proposals for measuring funds' level of risk, and why they miss the point.

What does “cautious managed” mean to you? Is it at the lower risk end (cautious) of a high-risk category (managed)? Or just safe? Or maybe low risk?

That’s the problem with many of the terms that describe the risk or volatility of investment funds. One man’s risky bet is another man’s security blanket.

A common scale

What we really need is a common scale on which we can measure risk, where everyone understands what sort of risk they are taking, and where they fit on the scale.

A great example of this approach is the EU energy consumption directive – this gave rise to the labels that give an energy rating from A (green) to G (red). The scale is now found on all new washing machines and other white goods, as well as cars and lightbulbs. Some appliances also use the A to G scale for other features such as how efficiently the machine washes or dries.

The A doesn’t mean the same thing for dishwashers (the number of kilowatt-hours per 12 place setting) as it does for cars (grammes of carbon dioxide per kilometre). But everyone understands the scale – A/green is low energy consumption and G/red is high-energy consumption.

The proposals

The two leading bodies that categorise investment funds in the UK – the Investment Management Association (IMA) and the Association of British Insurers (ABI) - have each put forward their own proposals for categorising mixed or managed funds.

The IMA has come up with proposals for an A-B-C-D scale, with D the lowest risk (which incidentally is the opposite direction taken by the energy consumption scale). The ABI has taken a different tack, by looking at the proportion of the fund that is invested in shares.

However, even the lowest risk option in either of these scales - let’s call it defensive - is not what the average consumer would necessarily call low risk.

If we start with the assumption that the scale would cover packaged investments, like deposit accounts, unit trusts and OEICs then we might start with deposits (up to £85,000 per bank) at the low risk scale, and then maybe fixed interest funds before we even reached the cautious managed fund.

So, in energy scale terms, the cautious managed fund might come in at C and the adventurous managed fund (the one with a lot of shares in its portfolio) at F. And given the range of packaged investments available, we might need more than seven categories in an investment scale.

The next step would be for investors to find out where they fit on the scale. Coming back to energy consumption, most people might prefer the A or green end of the scale, like Caroline Lucas, the Green Party leader. But others, Jeremy Clarkson for example, might actually prefer washing machines with four-litre twin-turbo power units that are a deep shade of red.

What risk profile do you want?

Most people get energy consumption. They might not know that green equals less than 0.5kWh or 100 g/km, but they know that green equals the lowest consumption.

The same is not true of investments. Some consumers may understand that most deposits are less risky than most shares but they are less likely to know what their own preference is without a little bit of help.

Therefore, in addition to coming up with a risk scale, we need to give customers tools to find out where their comfort level lies when it comes to risk and reward.

This is not rocket science and risk profile questionnaires are already widely used by financial advisers. Ideally, we want to come up with just one version that all customers can use, rather than a vast numbers that spit out different answers for the same person.

Standard Life has taken a step in this direction by developing a free and anonymous online risk questionnaire in conjunction with Oxford Risk. In addition, we have launched a range of fund portfolios called MyFolio to help people choose a portfolio that meets their attitude towards investment risk.

Although there is no wider market context for the risk range of the MyFolio funds, (for example are they A, B, C or C, D and E?), the combination of a risk questionnaire and funds designed to match the answers from the questionnaire are a big step forward in helping people find an investment that will meet their needs.

Perhaps in the longer term it will be possible for our customers to compare the ratings of the MyFolio funds against those available from other investment managers.

And once we’ve cracked the investment risk scale, then maybe, like washing machines, we could use the same scale to measure something else – charges for example?

John Lawson is head of pension policy at Standard Life.