Do we need to redefine the term investment risk?

We talk to clients about investment risk all the time. But the whole system around investment risk is wrong and it is doing a disservice to clients and it is resulting in them losing money.

ESMA Ratings

Life companies use the ESMA rating system to assess the risk of their funds. There is a rating system of 1 – 7, with 1 being the lowest risk and 7 being the highest risk. Cash is a risk rating 1, while Emerging Market funds and an Irish Equity fund are rated 7. The MSCI World Index and the S&P 500 are deemed 6 out of 7.

What is that telling clients? I honestly don’t know. I would have thought that a real risk of losing all your money is as high a risk as you could get. Not investing in Irish companies. If we look at the Irish index, it is a concentrated index with the top four of CRH, Flutter, Ryanair and Kerry Group making up 67% of the entire index. But does is it as risky as you can get?

How is investing in the biggest and most successful companies in the world deemed to be in the top 15 percentile of investments that you can make? The combined value of the world’s two biggest companies, Apple and Microsoft is $5.46 trillion. How risky is that really?

Risk profiling tools

Most risk profiling tools are not fit for purpose and shouldn’t be used at all. The process spits out a fund for you to invest in as a result of answering a few multiple choice questions. Risk profiling specialists Finametrica say that the risk profiling score should be the start of the conversation but for many it is the end.

Let me tell you the case of Paddy who completed a risk profiling questionnaire for me years ago. He was coming up to retirement and we were planning on implementing his ARF. As part of the process, he completed a risk profiling questionnaire and scored in the top 10% of risk takers. You see, Paddy loved playing poker and would often to Vegas to playing cards. But as we had a conversation about his score he said to me “But Steven, the money in my pension is all the money I have in the world. If I lose that, I’ll have nothing. I can’t afford to take risk with it.”

Now consider those risk profiling tools that automatically place someone in a fund based on the results of their questionnaire without having a conversation with them! Paddy would have been in Irish equities!!

Or the retiree who’s is deemed “low risk”. They will end up in mainly bonds. How did bonds do last year? They fell by -15%. Is that what you think of when you think of low risk?

Lets be real about risk

Real investment risk is investing your money with the chance that you lose it all. In the world of investment funds, what we are really looking at is volatility. How much can you money go up in down in value, especially over the short term. The S&P500 started in 1957 and the worst one year return was -43.32% in 2008. It also grew by 61.01% in 1982. But over that period, there is no instance where someone who held the S&P500 for at least 15 years had a negative return and the average return is about 10% per annum.

Cash is deemed to be low risk. It is given the lowest risk rating of 1 of out 7 on the ESMA rating because it doesn’t go up and down in value much. Over the last three years, it has returned 0.83% but the Irish Consumer Price Index has increased by 13.74% over that period. In other words, the real value of your money has actually fallen substantially so your money is worth a lot less now than it was 3 years ago. In that time, the risky US Stock Index has increased by 54.31%. If you had stayed in cash, your money would be worth less than when you started. If you invested in stocks, it would be worth more. The difference is one visibly goes up and down in value. The other is just worth less in real terms.


Clients need to understand that when they invest their money in funds, a fund that is 6 out of 7 isn’t as high a risk as it is portrayed as.


Steven Barrett

07 August 2023