The risk scales used by the regulated financial sector are broken. Here’s why

For many years now, the regulated investment industry has attempted to classify both investment products and investors on a scale of risk – sometimes 1 to 5, sometimes 1 to 7 and sometimes 1 to 10.

The idea is simple and uncontroversial enough – a very cautious investor who cannot stomach any fluctuations in value would be a 1/10, and should only buy products that are 1/10 on the risk scale. While very-high-risk products that are 10/10 for risk (or 5/5 or 7/7 depending on whose scale you used) would only be purchased by investors willing to take that risk. Most people fall somewhere in the middle.

This idea of a risk scale found its way into regulation; everyone who offers investment products to the public in the European Union has to issue a Key Investor Information Document which shows where its product sits on a scale of 1 to 7, determined by its volatility (how much its product goes up and down on a daily basis).

KID and DT risk scales
Two common risk scales: the first is used by Distribution Technology (a leading risk profiling firm), the second is the risk scale mandated for use in Key Investor Documents by EU law. The third is the scale they are measured against; the investment’s volatility (how much it goes up and down).

Here is the problem with these risk scales: whether the scale tops out at 5, 7 or 10, they only consider products available via the regulated investment sector, and whose moving parts are listed on mainstream stock markets. This means a 10/10 risk investment is considered something like an emerging markets or smaller companies fund.

But there are quite obviously many investments which are higher risk than an emerging markets fund – many of which are routinely held by retail investors, such as individual shares or buy-to-let residential properties. These investments can not only fluctuate by more than 10/10 risk-rated funds; they can generate permanent and total losses.

Why is this a problem? Because promoters of unregulated investments have been known to hand-wave away the risk of losing money by saying something along the lines of “all investments have risk”. Logically, this is like chucking a novice swimmer in the deep end of the pool and then saying “all swimming pools have water”. They are denying that there is such a thing as a scale at all.

But if the experts routinely use a risk scale that can’t accommodate even commonplace investments like individual blue-chip shares and residential properties, how is the investor supposed to know which end of the pool they’re about to jump into when they’re offered an investment that doesn’t sit on the scale?

Instead of focusing on volatility (which falls apart at the higher end of the risk scale where volatility cannot be measured), the following risk scale measures investments by what retail investors actually want to know, which is a) can I get my money out? b) can I lose money?
 

Short term risk Long term risk
 Low risk

e.g. Easy-access deposit guaranteed by FSCS or other depositor protection scheme

Negligible risk of loss Negligible risk of loss
Medium risk

e.g. Globally diversified portfolio of mainstream regulated equity funds

Fluctuates in value; bought and sold daily Negligible risk of permanent loss if held throughout the market cycle
High risk

e.g. Single-sector or single-country regulated equity fund

Fluctuates in value; bought and sold daily Risk of long-term loss even if held throughout the market cycle
Extra high risk type A

e.g. Individual buy-to-let residential property

Fluctuates in value; may be difficult to sell quickly Risk of permanent loss
Extra high risk type B

e.g. Individual S&P 500 or FTSE Main Market equity

Fluctuates in value; bought and sold daily Risk of total and permanent loss
Ultra high risk

e.g. Unlisted individual loan notes, unregulated fund which can borrow to invest

Fluctuates in value; may be illiquid; may be impossible to sell quickly Risk of total and permanent loss
Scam

e.g. Ponzi scheme, advance fee fraud, binary options scam, etc

Near-certainty of total and permanent loss Near-certainty of total and permanent loss

There are investments which do not sit comfortably in the above table, such as FSCS-protected fixed term deposits (low risk but illiquid) or bricks and mortar funds (generally considered medium risk but illiquid at times of crisis). However, these are niche solutions and the above table shows the progression of risk through the more common investments.

For those less familiar with the investment market, a little more explanation:

By a medium-risk “globally diversified portfolio” we mean a portfolio holding thousands of securities representing all global stockmarkets. This could be a single highly diversified multi-asset fund or a mixture of single-sector funds. Although such a portfolio will at times experience severe falls in value (in the last major crash in 2008, a typical fall was 30-40%), as long as the portfolio is properly diversified, the investment will recover when global stockmarkets recover.

By a high-risk investent we mean those which can lose money in the long term even after global stockmarkets have recovered. There were Japanese funds at the end of the 1980s which never recovered from the “lost decade”, even though they were diversified across lots of Japanese companies. This is why no-one should have all their money invested in Japan, or any single country, even if you live in it.

An extra high risk investment has no diversification, and is different from a plain high risk investment in one of two ways. Either a) it is illiquid and difficult to sell, or b) it is liquid but presents a risk of total and permanent loss (like S&P 500 or FTSE Main Market shares).

Residential property falls under type a), despite being considered by many laypeople as “safe”, because the reality is that residential properties can and do lose money if you get a bad tenant and have to spend money repairing the house instead of making money, and if the house fails to appreciate in value. (House price indices generally go up, but individual houses don’t always.)

An investment which has both illiquidity and risk of permanent and total loss is an ultra-high-risk investment.

A total loss is by its nature permanent.

People often make mistakes when managing medium- and high-risk investments (like betting too heavily on Japan or cashing out at the wrong moment) but as these investments have very little risk of total loss, these mistakes are usually fixable. And because these investments are generally liquid, the investor can correct their mistake as soon as they recognise it, albeit at a cost.

By contrast, someone who mistakenly invests in an ultra-high-risk investment does not usually realise their error until the money is already gone. And there is nothing to switch into a more diversified portfolio, and no way of correcting their error.

This is why developed regulatory systems have at their core the belief that unregistered securities should not be sold to the general public. There is no point saying caveat emptor if the emptor has no way of knowing they should cavere until their wallet has already been emptied.

This is of course all a little academic: ultra-high-risk investments are generally exempted by the EU regulatory system from any requirement to hand investors a document which might show that they are being offered a maroon-level ultra-high-risk investment (as opposed to a “secured” “asset-backed” “insured” “bond”). But we can dream.

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