Traditional investor risk profiling ‘not enough’ in periods of volatility

Traditional risk profiling of investors is not enough, and advisers and providers need to understand emotional responses to volatility and which solutions investors can realistically stick with over time, a white paper from Oxford Risk and Standard Life has argued.

The joint paper, Beyond Risk: Matching Solutions to People, comes amid heightened uncertainty in markets and the Consumer Duty placing greater focus on demonstrating genuine client benefit.

Oxford Risk and Standard Life therefore argued that the need to understand the full picture of an investor’s emotional and financial circumstances has never been more pressing.

Most investors were falling short of their long-term goals because they struggle to maintain their investment strategy if facing emotional discomfort, rather than a lack of financial knowledge, according to the paper.

It noted that investors tended to panic and sell when markets fall, and chase performance when they rise, leading to a behavioural gap between good intentions and real-world actions that lead to costly deviations for suitable long-term investment plans.

The report highlighted the importance of ‘behavioural capacity’, which it defined as an investor’s emotional ability to stay invested through volatility, complementing traditional measures of willingness and financial ability to take risk.

While traditional portfolio construction is typically centred on risk-adjusted returns and often assume investors are emotionally neutral, the firms warned that failing to account for investors’ emotions risked negative outcomes if the investor cannot stick with the plan.

The paper introduced ‘anxiety-adjusted returns’ as a lens for understanding the outcomes investors can realistically achieve one the emotional costs of an investment journey are accounted for.

It argued that advisers and providers should focus on building portfolios that investors can maintain through periods of market volatility, rather than simply maximising expected returns.

"Suitability is not just about the risk an investor can afford financially; it is about the journey they can endure emotionally,” commented Oxford Risk head of behavioural finance, Greg Davies.

“Too often, those two things are treated as the same, and they are not. A technically optimised portfolio can still fail if the investor cannot live with the journey.

“Our behavioural fit to smoothing framework helps advisers identify where volatility is likely to become behaviourally costly, and where smoothing can provide useful emotional support.

“The goal is not to eliminate volatility. It is to help investors stay with a suitable long-term strategy in good times and bad."

Looking at ‘investment smoothing’, which is designed to reduce the visible peaks and troughs of portfolio values as markets move, the paper argued it was not a universal solution.

While for some it offered a buffer against the anxiety of volatility, it may add unnecessary cost or complexity without benefit for others.

The firms therefore highlighted the important of understanding who is most likely to benefit and why, which requires going beyond demographics or a single risk score to understand deeper behavioural traits, as well as adviser-led contextual judgement.

“Taking a long-term view of investing requires understanding what causes investors to come off track, and volatility is one of the biggest threats to long-term outcomes because of how it can affect investor behaviour,” said Standard Life head of smoothed managed funds, Mark Baldwin.

“Today’s white paper explores this further, highlighting that when people feel more confident through periods of uncertainty, they’re more likely to make good decisions and remain invested over the long term.

“In this context, smoothed funds can play an important role in helping investors stay the course. By stabilising portfolio values during volatile periods, they can provide the reassurance needed to remain committed to a long-term strategy and improve outcomes.”

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