The familiar investment risk scores 1-7 are used consistently throughout the EU in an effort to protect consumers. It is felt, justifiably in the opinion of MMPI, that numbers on the scale represent risk levels that are easier to pin-point than, say, English words like careful; conservative; balanced or their foreign language equivalents. The 1-7 risk measures are termed Summary Risk Indicators because they summarise the primary investment risks, which are credit risk (the chances of the underwriter going bust) and market risk (the chances of erratic and damaging price changes).
In an effort to take overt subjectivity away from the calculations; as much science as possible is used to determine the risk scores. This unfortunately results in arithmetic formulae that belong in a dimension well-beyond the average brain. However, this should not stop us trying to get to grips with the basic, underlying concepts.
Volatility and probability are the key stumbling blocks to understanding the calculations. Both notions are simple to explain in theory but are fiendishly difficult to rationalise in practice. For our purposes, volatility is the extent to which prices can change rapidly and unpredictably; while probability is the extent to which this is likely to happen. Humans can often get drawn into a complacent mind set by not visualising extreme events and accepting only those that form comfortable patterns around standard norms. Hence, we fail to accept that events could be so unpredictable that the whole banking system could fail or that market prices could deteriorate exponentially. “That will never happen” is a frequent fall-back position.
Summary Risk Indicators make a sound attempt at bringing potential volatilities and probabilities to the fore; and displaying the measures on a 1-7 risk scale. But in so doing, the 1-7 risk scale becomes skewed in a way few consumers realise – the sequential gap between one risk level and the next is not consistent. This means that risk level 1 is not simply 6 small steps away from risk score 7 – it is “light years” away. It also means that the risk calculation that displays as, say, 4 but is only a smidgeon away from scoring 5 is not adequately explained on the simple 1-7 risk scale.
By measuring the value of the investment that is likely to be at risk as a result of extreme volatility events the scores equate as follows:-1= <0.5%; 2 = 0.5% – 5.0%; 3 = 5.0% – 12.0%; 4 = 12.0% – 20.0%;5 = 20.0% – 30.0%; 6 = 30.0% – 80.0%; 7 = >80.0%
This demonstrates the distorted nature of the outcomes and highlights how far risk level 1 is removed from 7. It also reveals that a score of, say, 29% (5) is very close to being associated with an 80% score at risk level 6. The methodology is not fool-proof and clearly has its flaws – but it is far better to have objective calculations rather than subjective storylines, which were the practice in the not-too-distant past!