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The ideas and conclusions within these blogs are the authors' own and do not necessarily reflect the views of Octopus. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any investment. For our full terms and conditions, please click here.

Risk profiling – a vital tool to help identify client risk

Guy Myles - 23 September 2011

In June this year, the Financial Services Authority (FSA) reviewed the client files of a sample of 16 wealth management firms, and its findings were shocking. Of the 16 wealth management firms reviewed, 14 were found to have portfolios that were deemed to have “a high risk of unsuitability”, of potential detriment to their customers, or where suitability could not be determined.

For those investors (or financial advisers) entrusting the responsibility of wealth preservation or creation to a professional manager, this is a disturbing statistic to read. When the FSA finds a high risk of unsuitability with seven out of eight client portfolios it reviews, clearly there’s a breakdown in the client/adviser relationship.

As a result of its findings, the FSA wrote to the chief executives of 260 wealth management firms, warning that many “were not adequately recognising the risks that clients were willing to take...the client's attitude to risk, their investment objectives, investment horizon or the agreed mandate”. Clearly, when it comes to assessing a client’s attitude towards risk, and an investment’s suitability, there’s an expectation from the FSA for far more robust and comprehensive analysis to be undertaken from the outset.

Before we start talking about any solutions, however, let’s look at what risk really means. Risk represents the chance of something undesirable happening – in this case a financial loss. In investment terms, it’s usually followed very closely by a discussion about ‘reward’ – a positive outcome, or financial gain. This is because there’s a trade-off between the two and the right investment for any individual should strike the balance that’s most appropriate to them.

Some investors, for example, want a high level of return and are willing to take some risks with their capital in order to achieve it. Others may simply prefer that their savings won’t be eroded over time by inflation and want to keep any potential loss to their initial investment to a minimum. Many may have a long term savings goal in mind, but don’t know the right balance of investments needed to help them get there.

Getting an investor’s attitude to risk right, clearly and well in advance of any product recommendation, has to be the goal for all advisers. To this end, advisers use risk profilers to ensure a consistent analysis of an individual’s position on the risk/reward spectrum.

Octopus has hundreds of conversations with the adviser community every working day. Their feedback helped us to develop our bespoke risk profiling tool. Since its original incarnation we have refined it based on the best practice guidance contained in the FSA report mentioned above.

The Octopus Risk Profiler was designed to be used alongside Octopus Portfolio Manager, a service that allows advisers to select from ten separate investment profiles, each targeting a different level of risk and return. It allows advisers to create an individually tailored investment portfolio, based on the client’s financial requirements, investment goals and view of risk over the long-term.

The profiler analyses a potential investor’s risk tolerance based not solely on their ‘attitude to risk’, the common denominator in most risk profiling tools, but also their ‘capacity for risk’, for which two separate investment requirements are taken into consideration. The former plots investors on the risk/return spectrum (i.e. asking how much risk they are willing to take), whilst the latter evaluates whether an investor is in a position to take that risk (i.e. determining how much risk they are able take).

Risk profiling is clearly high up on the FSA’s agenda and it has the potential, if not carried out correctly, to have a detrimental effect on both advisers and investors. We believe that it is fundamental for advisers to integrate risk profiling within their suitability process, as a way of demonstrating that the investment advice offered is credible, reasonable and underpinned by a robust analysis of risk tolerance.

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Please remember that past performance is no guide to future performance and may not be repeated. The value of investments and the income derived from them may go down as well as up.

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The investments referred to on this website may not be suitable for all investors. Octopus does not provide, and nothing on this website should be construed as, investment or tax advice. Potential investors are recommended to seek specialist independent tax and financial advice before investing in any of our products. It is not intended that anything stated in this website should be construed as an offer, or invitation to treat, or inducement for you to engage in any investment activity. The information on this website relating to funds managed by Octopus is directed at United Kingdom residents only and funds referred to on this website will not be offered to non-residents.

Please remember that past performance is no guide to future performance and may not be repeated. The value of investments and the income derived from them may go down as well as up and you may not get back the amount originally invested. Tax rules and regulations are subject to change.

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Investments in unquoted and AIM-quoted companies tend to carry a higher risk than investments in most securities listed on the main market of the London Stock Exchange and may be more difficult to sell. The inheritance tax relief applies to holdings in qualifying unquoted and AIM-quoted companies if they have been held for more than two years at the time of death and is based on current tax rules and regulations. Money that is withdrawn from qualifying holdings, or that has not been invested in qualifying unquoted or AIM-quoted companies for at least two years, will not generally be exempt from UK inheritance tax. We will invest in companies that we reasonably believe to be qualifying investments based on our understanding of HMRC's current interpretation of the rules and regulations, but we cannot guarantee this, nor can we guarantee that any changes in legislation will not have a retrospective effect. Please remember that tax rules and regulations are subject to change and depend on personal circumstances. The level of income from the Octopus ITS is not guaranteed.

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Investments into an EIS must be retained for a minimum of three years in order to retain the upfront income tax relief. Investments made into EIS qualifying companies, because they are in unquoted companies, are likely to be higher risk than securities listed on the main market of the London Stock Exchange. Investments in shares in unquoted companies are not readily marketable and the timing of any share sales and other such realisation cannot be predicted or controlled. A partial withdrawal of an investment in an approved EIS fund is not permitted. Tax rules and regulations are subject to change, and depend on personal circumstances. Readers of this website who intend to invest in Eureka or the Octopus EIS are reminded that such an investment may only be made on the basis of the information and other risk factors contained in the product brochure. Octopus will make investments which we reasonably believe to be EIS qualifying investments at the time of acquisition (but please be aware that we give no commitment that any such investment will remain a qualifying investment at all times thereafter). Companies in which we invest may cease to qualify. In this case, the relief available on that particular investment will be lost.

Octopus Accelerated Discounted Gift Trust

Investments made by the Octopus ITS, because they are in unquoted companies, are classified by the FSA as higher risk than companies on the London Stock Exchange official list. An investment in the Octopus ITS is not suitable as a short-term investment and should be held for at least two years. Rates of tax, tax benefits and allowances described in the brochure are based on current legislation and HM Revenue & Customs practice. These may change from time to time and are not guaranteed. In this case, the inheritance tax relief available on the investment may be lost. Changes in law can have a retrospective effect. The Octopus Enhanced Discounted Gift Solution has been designed with UK-resident taxpayers in mind. If you are not resident or ordinarily resident in the UK for tax purposes, it may not be appropriate or advantageous for you to invest in this product. This product utilises a trust to facilitate planning. Trusts are a legal arrangement and prospective investors are advised to seek legal advice if they are unsure of their rights and obligations. The taxation of trusts can become complicated, and investors should seek tax advice from a professional adviser.

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CFIC Octopus UK Micro Cap Growth Fund

The fund will invest in securities issued by smaller companies and the market for these securities may be less liquid than the market for securities issued by larger companies. Investment in smaller companies (including companies quoted on AIM) can be higher risk than investment in larger, more established companies and as a result, the performance of the fund may be more volatile. The fund can use both ‘long' and ‘short' positions in individual stocks and markets, which may be more volatile than other investments, such as cash or bonds, and the value of the fund can therefore move independently from the general direction of the stock markets, rising as markets fall but theoretically it can also fall as markets rise. Octopus uses a risk management process to oversee and manage derivative exposure within the fund. The investments made by the fund may not always be readily realisable and their marketability may be restricted. As the fund may invest in a comparatively small number of companies, it may be more volatile than funds that are more diversified. Before investing, please ensure that you have read the information set out in the simplified prospectus, which includes full details of the charges. The authorised corporate Director is City Financial Investment Company Limited.

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Before investing, please ensure that you have read the information set out in the Octopus Portfolio Manager brochure. An investment in Octopus Portfolio Manager should only be considered for the medium to longer term. Tax laws currently in place may change in the future, which could affect the value of an investment. There is no guarantee that the investment objective of the Octopus Portfolio Manager will be achieved. We do not take responsibility for, nor do we provide advice as to, the suitability or appropriateness of the specific Investment Profile selected by an investor. We reserve the right to decline any application where the applicant has not received professional financial advice. It is the responsibility of the investor (on the advice of their financial adviser if appropriate) to keep their financial circumstances, objectives and appetite for risk under review and to assess whether the specific Investment Profile that has been selected remains suitable for their needs. We shall not be liable for any losses that an investor suffers as a result of their selection of a specific Investment Profile and cannot and do not make any representation that such selection is suitable or appropriate for the investor's specific needs and requirements.

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