Download Risk Profiling

November 2011
A guide to
risk and risk profiling
another
Avoiding avoidable
mistakes
publication
The new imperative
Contents
Introduction .............................................................................................................................. 3
Risk ............................................................................................................................................ 4
Risk Profiling .............................................................................................................................. 8
Maximising returns or minimizing risk? ................................................................................ 18
Appendices ............................................................................................................................ 20
Bibliography ........................................................................................................................... 21
About farrelly’s ....................................................................................................................... 22
Farrelly’s
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Introduction
This Guide should be read in conjunction with the farrelly’s Investment Strategy
Handbook.
The core premise behind this guide is that risks are anything that can get in the way of
an investor achieving their long term goals. Or, put another way, risk is the chance
that a long term investor does not meet their goals. Once investors understand what
those risks are they are in a much better position to assess whether or not they are risks
that they wish to take.
So we begin by looking at what factors can get in the way of an investor meeting
their goals. These we essentially divide into two groups, those which can make the
investment journey too uncomfortable to tolerate and those which have the potential
to see the investor’s long term goals not being met.
We then go onto a discussion of how we may assess an investor’s psychological risk
profile – essentially their ability to tolerate ups and downs during their journey, and
their financial risk capacity which is their ability to cope financially with poor
investment returns.
We then finish with a discussion on whether an advisors role is to maximize returns or
minimize risk – a key philosophical dimension that all advisors should consider.
Farrelly’s
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Risk
The whole purpose of investing is to meet some financial goals which are normally
defined by the investors needs. For the majority of investors the goal is to generate
sufficient returns in order to fund income in retirement. Given that meeting needs is
the objective, farrelly’s defines risk as the chance that investors don’t meet their needs
– the chance that investors will not have the money they need when they need it.
This is in stark contrast to the majority of the financial community which defines
investment risk as short-term volatility or tracking error, or some other similar statistical
notion. (For more discussion on the shortcomings of popular measures of risk, see
Towards a Better Measure of Risk1)
When looked at in the this way, it becomes clear that risk is multidimensional. We
should be concerned about all the things that can get in the way of achieving the
investor’s objectives. Such things may include short-term volatility, poor manager
performance, credit failure, illiquidity, inflation, poor long-term market returns – and
any other risk that can hurt the investor. However, managing all those risks
simultaneously is no easy task. To help, farrelly’s sub-divides all these risks into two
separate groups:

Those risks associated with the investment destination – will the strategy achieve
the investor’s objectives?

Those risks associated with the investment journey – how will the investor fare
along the way? Will the investor be able to stick to the strategy?
Figure 1: Risk categories
Risk category
The journey – will the investor stick with the
strategy?
What can get in the way
Short term volatility
Tracking error –will returns be different from everyone
else?
Fluctuating income levels
The destination – will the strategy achieve the
investor’s objectives?
Poor long term market returns
Credit failure
High inflation
Excess chopping and changing of strategy
Farrelly’s
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WHICH SHOULD WE WORRY ABOUT – THE INVESTMENT JOURNEY OR DESTINATION?
Let’s look at an analogy. You have an important meeting on the other side of the city
that starts in an hour, how best to get there? You could drive yourself, but you are
unfamiliar with the area and may get lost and so miss the meeting. You could catch
a cab, but that’s expensive and you may not find one in time. Or, you could catch a
train, which you know stops right outside where you have to go, but you hate
travelling on trains.
In this case, the decision should be pretty easy. The primary objective is to make the
meeting, so you should take the train – unless, of course, your dislike of trains is so
profound that you doubt that you will be able to last the whole journey or, if you do,
that you will be unable to function at the other end.
And so it is with investment, where we worry about both the journey – will the portfolio
be too volatile for the investor to stay the course – and the destination – will the
portfolio produce the returns required to meet the investor’s goals?
Unfortunately, most of the industry seems preoccupied with the journey. Most
discussion of product and portfolio risk centers around short-term volatility and how
much of it can be tolerated.
Too little discussion is focused on the range of long-term, after-inflation returns that a
portfolio will achieve – that is, will we arrive at our required destination?
Is this distinction worth making?
farrelly’s believes it is crucial. Consider a 10-year Treasury bond yielding 5.5% per
annum. Over short time horizons, it displays considerable volatility. But what level of
uncertainty is there about the level of returns that will be earned by that security over
a 10-year time horizon? None – the return will be exactly 5.5% per annum. In this case,
short-term volatility and long-term return uncertainty are quite unrelated. If I am only
concerned about the return I will earn over the time horizon of the investment, the
short-term volatility of bonds is a complete irrelevance.
Consider appraisal-based assets – for example, direct property or infrastructure
investments. How many studies have we seen where such assets are touted as having
low risk and wonderful diversifying properties? By focusing on the journey and not the
destination, these studies miss two crucial points:

Low volatility does not equal low risk. For example, direct property syndicates are
certainly low volatility, but to describe these investments – which generally have
highly geared and concentrated portfolios – as low risk would obviously be a
nonsense.

As these assets are generally substantially illiquid, the only true measure of their
diversifying characteristics is what they do at the end of their investment time
horizon, not what they do along the way.
In the event that other markets have been punished over the long term, will an asset
produce a high level of returns to compensate, or will it succumb to the same broad
economic forces that caused other assets to perform poorly? Until that question is
answered, we really have no idea whether an asset is, or is not, a good diversifier for
long-term investors.
Farrelly’s
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HOW DOES THE HANDBOOK DEAL WITH RISK?
farrelly’s believes that both the journey and the destination are important, and so
both long-term and short-term worst-case scenarios are provided for individual assets
and portfolios.
The journey – worst-case short-term scenarios
In the Handbook, you’ll find farrelly’s estimates of the worst-case scenarios for different
asset classes at given levels of probability. For example, for Australian equities, the
worst case scenario with a 1-in-50 probability is for a loss of 65%; with a one-in-20
probability of a loss of 38%. These scenarios are determined from the short-term
volatility data. However, they are compatible with historical data. By way of
comparison, during the last 60 years, the Australian market has fallen by more than
50% in a twelve month period on just two occasions – in 1974 when it fell by 50.5% and
during the global financial crisis when it fell by 55%. It has fallen by 38% or more on
four occasions – in 1974, 1981/2, 1987 and 2008/9.
These returns ignore the impact of inflation, as it tends to be relatively minor over a
twelve-month period in comparison with falls of this nature.
The destination – worst case long-term scenarios
This risk measure estimates the worst case 10-year real (that is, after inflation) returns for
individual assets and portfolios. For example, in the September 2011 Handbook, the 1in-20 worst-case scenario for bank term deposits was a pre-tax, post-inflation return of
just 1.1% per annum. Given that we know the five year return on term deposits was
then 6.3%pa, this measure is saying that there is a 1-in-20 chance of inflation
averaging above 5.2% per annum over the next decade.
Interestingly, if we used this measure in September 2011 to compare a 100% bond
portfolio with a diversified portfolio, we would have seen that a conservative,
diversified portfolio had a 1-in-20 worst-case real return of 1.9% per annum, well ahead
that of the fixed interest portfolio. So, by this measure, a diversified portfolio with 40%
in risky assets carried less long term risk than a pure fixed interest portfolio, even if it is a
lot more volatile. Do we worry about the journey or the destination?
(As an aside, this will not always be the case. At a time when risky assets were
relatively expensive then even a diversified portfolio would have more long term risk
than a pure bond portfolio.)
Estimating long-term risk
To arrive at our estimates for worst case returns, farrelly’s thinks about different
economic scenarios that may develop over the coming decade. For example, will we
experience a continuation of low inflation and solid growth, or will we see inflation reemerging? What is the chance of a major recession or even depression? farrelly’s
thinks of how those scenarios may manifest themselves, and what impact they may
have on the key assumptions that drive the Occam’s Razor2 forecasts – inflation, PE
ratios, growth rates of earnings and rents. In other words, this is a forward-looking
estimate of risk.
Farrelly’s
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This is discussed in more detail in “farrelly’s guide to forecasting asset class returns and
risks.”
The destination should be the primary focus when creating model asset allocations
While the journey is important, farrelly’s believes that advisers should keep their eyes
firmly on the destination – that is, not only to continue to ask “What can go wrong with
this investment?” but also, “When will this investment fail? What will be happening to
other investments in this scenario?”
This is particularly important in an investment landscape that has become more
heavily populated with non-traditional investments that often have seductively benign
short-term volatility characteristics.
It is why farrelly’s focuses on long-term real risks when constructing its model asset
allocations. When a smooth trip to the right destination is not possible, we would
prefer a rough trip to the right destination over a smooth journey to the wrong one.
With the model asset allocations in the Handbook and in the Investment Strategy
Implementor, the key measure of risk used is the worst-case, real, long-term return.
What that means is that portfolios will be designed to maximise long-term returns for a
given level of risk of low long-term real returns.
Farrelly’s
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Risk Profiling
The purpose of investor profiling is to help decide what sort of portfolio is appropriate
for any particular investor given their needs and tolerance for risk. As a result risk
profiling is not an end in itself but, rather, is inextricably interwoven with the
identification of needs.
As with the discussion on risk, we divide risk profiling into two parts

The ability to bear risks associated with the journey – that is, the investor’s
psychological risk tolerance; and,

The ability to bear risks associated with the destination – that is, the investor’s
financial risk capacity.
Psychological risk tolerance is an attribute of an individual that describes how
receptive they are to ideas involving risk, and their ability to cope emotionally with the
stress that can be caused by volatility and uncertainty during the investment journey.
Financial risk capacity is the ability of an individual to cope financially with poor longterm financial outcomes – that is, will they arrive at the desired investment destination.
The two concepts are quite separate, and should be kept separate. Both represent a
different constraint on the final portfolio. Both should be satisfied.
To pick up on the train trip analogy from the previous section, when making a journey,
we have to be happy both that it will be sufficiently comfortable and that the train will
get us to the right place. Some combined assessment, for example, an average of the
two, just won’t do. A very comfortable train ride is no compensation for arriving at the
wrong destination. Similarly, a train that arrives early is no compensation if the
passenger is no longer on board.
By way of illustration, imagine a stockbroker who retires after 40 years in the industry.
He has seen it all and fully understands and is totally comfortably with share market
risk. Should he invest 100% in the share market?
Those who focus on solely on psychological risk tolerance tend to say that very high
share market exposures are just fine for this type of investor. The journey will be fine, as
he does understand, and is comfortable with, the risks involved.
But what if the ex-broker has said that his absolute bare minimum lifestyle
requirements are such that a real return of at least 1% per annum is required from his
investments? He is now describing his financial risk capacity, which is that he could
not tolerate the consequences of long-term, real returns below 1% per annum – and
as any investor in the Japanese sharemarket can tell you, this a real possibility for an
investor with a 100% exposure to the share market. US investors are also, slowly,
coming to recognize this reality. Actually, poor long term performance from growth
Farrelly’s
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assets is not at all uncommon as illustrated in Avoiding Avoidable Mistakes3 and it I this
possibility that makes assessment of risk capacity so important.
In practice, it is the lesser of psychological risk tolerance and financial risk capacity
that will drive portfolio selection. This is because both constraints need to be satisfied.
In order to put these ideas into practice we suggest a four-step process for finding a
portfolio that matches an investor’s risk profile:
1.
Determine what needs the portfolio is required to fund,
2.
Assess whether what sort of portfolio could meet those needs even if long term
investment outcomes are very poor - that is, assess the investor’s financial risk
capacity;
3.
Estimate how much volatility can be endured along the way – the investor’s
psychological risk tolerance; and,
4.
Find a portfolio that will satisfy all three requirements, which may require
revision of the needs as identified in Step 1.
Unfortunately, these steps are not ones that can be done using back of the envelop
calculations and simple benchmarks. Typically we will need some sophisticated
modeling tools to help us identify and communicate which portfolio is suitable for a
particular investor, and why. This is where the PAA Wizard and the Projector tool in the
Implementor software are very useful.
Below we will look at the four steps generically, and while doing that, will illustrate how
the Projector helps identify an investors risk profile in a simple, logical and rigorous
way.
STEP 1: WHAT IS THE MONEY NEEDED FOR?
If risk is the chance that we don’t have the money we need when we need it, then
any attempt at risk profiling should begin by understanding the investor’s needs.
Investments can be held for many purposes but for most investors, income in
retirement is a primary need. How needs can drive risk profiles is easily illustrated using
retirement income as the need to be satisfied. Let’s say Mr. and Mrs. Smith have
decided they would like a retirement income of $70,000 per annum, and to leave
$1,000,000 to their grandchildren. They may also wish to make a number of one off
payments such as a world trip post retirement or a gift to grandchildren which could
also be taken into account.
The factors that will have a bearing on whether or not they can achieve that goal will
include:
Farrelly’s

The capital they have today;

Their ability to save prior to retirement;

Their time until retirement;

Likely longevity;

Their spending pattern in retirement;
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
How much if any they would like to leave behind;

The tax rates they will pay on earnings pre and post retirement.

Whether the pension may supplement their investment returns

And, critically, what returns they may achieve
Using best estimates for returns allows us to estimate whether the clients are likely to
achieve their goal.
STEP 2: FINANCIAL RISK CAPACITY – WHAT IF MARKETS PRODUCE POOR RETURNS?
As we all know, no matter how useful they may be, no forecasts are perfect. Markets
can, and do, deliver outcomes that are much higher or lower than expected and the
more risk we take on then the greater will be the range of outcomes.
Ideally any projection software should be able to show not only the outcomes if
markets produce returns as expected, but also a range of outcomes reflecting
reasonable uncertainty for any particular choice of portfolios.
The farrelly’s Projector, does just that and in doing so allows an assessment of the
investors risk capacity. The Projector is contained in both the Implementor and the
Wizard software that form part of the subscription to the Handbook.
This information needed to complete the risk capacity assessment is described in Step
1. above, and is generally collected as part of the standard fact finding process. This
information is entered into the Projector input section which is reproduced in figure 2
below.
Figure 2 : Inputs into the Projector Software.
Age Now
Retirement age
Life expectancy
55
65
93
Average tax on investment earnings
Pre retirement tax rate
Post retirement tax rate
15%
0%
Capital now
Pre retirement earnings
Annual spending
Pre retirement savings
$
$
$
$
900,000
85,000 pa
70,000 pa
15,000 pa
Real rate of change of
post retirement spending
-1.0% pa
Pension Assumptions
% maintainance of Aged Pension regime
Single(1) or Married(2)
100%
Portfolio Model
3
1
While most of these inputs are obvious we offer a few comments for guidance.
Life expectancy – we suggest use of the Mylongevity.com.au. This is a free site that
takes into account family history, lifestyle and other factors to estimate likely longevity.
In particular this site estimates life expectancy taking into account expected
improvements in longevity which is in contrast to the current actuarial tables which
are based on current experience only.
Farrelly’s
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Tax Rates – The estimate is for the tax rates on investment earnings – that is excluding
tax paid on employment earnings. The default settings assume all investments are
held in super. Where investments are held outside of super then these rates should be
increased somewhat to reflect the average rate of tax paid on investment earnings.
If the current highly attractive super tax rates were believed to be unsustainable long
term then the assumptions could be increased somewhat. Don’t be too concerned
about precision here – who knows what average tax rates will be over the next 40
years? And, importantly, the results are not very sensitive to changes in assumptions
for tax.
Pension Assumptions.
The default settings assume that current pension payments will remain constant in real
terms. This is a somewhat conservative assumption in that it implies that pensions as a
percentage of average weekly earnings will fall over time given that wages tend to
rise faster than inflation due to productivity improvements. The married or single
variable should be the expected status of the investor at the time the pension kicks in.
For wealthy married investors, where the pension would only start in later years as
assets fell away, an assumption of the single pension may be appropriate as it is quite
likely that both investors may not be alive at life expectancy.
Earning and spending assumptions.
The key factors that drive the results are how much is saved pre-retirement and how
much is spent post retirement. If the investor anticipates an initial drop off in spending
post retirement, then adjust the spending input to reflects expected post retirement
spending and adjust the pre-retirement earnings so that the net after tax savings is
consistent with the amount that can be saved pre-retirement.
Real rate of post retirement spending change.
US research suggests that, on average, retirees spending gradually declines at about
1%pa in real terms. To apply that assumption enter -1% in the input field. Some
expect that this decline in spending will be offset by rapid increases in healthcare
costs. This input allows the user to change this assumption in either direction.
Portfolio Model
Finally, once all the data is entered, the Portfolio Model can be varied to see what
level of risk will produce an acceptable outcome for the client. Portfolios 1 to 5
represent different levels of risk; Portfolio 2 has similar risk to an industry standard
capital stable fund, Portfolio 4 similar risk to a balanced fund. Portfolios 1 and 5 are
the lowest and highest risk respectively with Portfolio 3, unsurprisingly, about half way
between 2 and 4 in terms of risk. We deliberately do not attach names to these
portfolios as we think they can be misleading or confusing.
In the Wizard software only 1 to 5 are possible inputs. In the Implementor software
entering 0 will allow you to assess a portfolio you have designed yourself in the
Bespoke Rebalance section of that software.
In both versions the projector can be used on a standalone basis to estimate risk
capacity
Farrelly’s
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Output – the projections.
Figure 3 below the output of the Projector. The chart illustrates a range of possible
outcomes for the investors real capital with the blue line showing the base case and
the red line the 1 in 20 worst case scenario. In other words the investor can have 95%
confidence that they will do better than the outcome shown by the pessimistic or red
line.
We suggest that the portfolio model be varied until the pessimistic forecast has the
investors capital running out at life expectancy. At this level of settings the investor
can have 95% confidence that their cash flow needs in retirement will be met, even if
markets produce poor returns.
Figure 3 : Output from Projector
Lifetime capital in todays dollars
Optimistic
In the example above the investor is presented with a strategy that should leave
$1,000,000 in real terms if things work out as expected but, in the event that the
markets deliver poor returns in the long term, the investor still has close to a 95%
chance that their income needs will be met – even if their capital is diminished along
the way. In order to arrive at this result the Projector estimates both expected returns
over the next decade as per our standard forecasting processes and also pessimistic
10 year forecasts and applies those to the required cash flows over time. After the first
decade all returns are assumed to revert to fair value returns, around 9.5%pa for
equities and property and 5.5%pa for fixed interest.
If the plan was for the investors capital to run out shortly after their life expectancy
under the expected scenario, then we believe that there is a much too high a
chance that this plan would fail. After all, if there is a 50% chance that the returns are
below our expected result then there is a 50% chance that the investor’s money
would run out early. No client would accept that if it were described in this way.
Thinking about risk capacity this way also facilitates a very useful discussion with the
client so that they are left in no doubt of the range of outcomes they may experience
and whether they can tolerate them.
Farrelly’s
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If they cannot accept the outcomes, then they can vary the inputs, how much they
spend, how much they save, how long they work and what type of portfolio they
decide to adopt.
STEP 3: PSYCHOLOGICAL RISK TOLERANCE – HOW MUCH SHORT-TERM VOLATILITY CAN
INVESTORS TOLERATE DURING THE JOURNEY?
Many factors will influence investors’ level of comfort and their ability to stay with a
strategy during the journey. These include:

The investor’s underlying psychological attitudes towards taking and accepting
risk;

The investor’s experience and understanding of their investments – generally,
greater experience and knowledge gives increased tolerance for volatility;

The level of regular income produced by the portfolio – generally, investors
receiving high regular income have less concerns about market volatility than
those receiving the majority of returns as capital growth.

The need for the investor to take control of their investments – delegators may be
just as unhappy as more active investors, but are less likely to insist that their
strategy is changed midstream.
Clearly, getting a handle on all of this is not a trivial exercise. Two approaches have
considerable appeal.
The first is to simply ask the client how much volatility they think they can handle. This is
the basis of the questionnaire in the farrelly’s Investment Strategy Profiler. While this
approach does not pretend to accurately measure the investor’s psychological risk
tolerance, it does go to the heart of the matter and facilitates a discussion and
agreement between the adviser and investor on what is an acceptable level of shortterm downside risk.
The farrelly’s short term risk profiling tool is reproduced on the following page.
Farrelly’s
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farrelly’s
INVESTMENT
STRATEGY PROFILER
For you to complete
Investment strategies should be designed to meet your personal and specific financial
goals. These goals may be to provide income in retirement, or to pay education expenses
for your children or perhaps to save for the deposit on a home. We refer to these goals as
your preferred investment destination – that is, what it is you are trying to achieve with your
investments strategy.
Different investment strategies entail different amounts of risk. One important aspect of risk
is the degree to which the value of your investments will rise and fall over time. Generally,
but by no means always, the riskier the strategy, the higher the returns and the bigger the
ups and downs along the way. We refer to the experience you will have along the way as
the investment journey.
Different individuals cope differently with market ups and downs. With the help of your
adviser, you can use this farrelly’s Investment Strategy Profiler to discuss and document the
key information needed for you to decide what sort of investment journey you can
tolerate.
You should discuss the results of this profiler with your adviser who will use it in conjunction
with information about your assets and objectives to design an investment strategy that
has the best chance of getting you to your preferred investment destination, consistent
with an agreed investment journey.
Central to this process is the fact that there are very few certainties in the investment world
– markets can and do rise and fall, interest rates can and do fluctuate. As a result, returns
can and do turn out much better or worse than expected – and, the higher the returns we
try to achieve, the higher the risk that something can go wrong and your objectives will not
be met. However, some risk is generally necessary because if a strategy is too cautious,
then, even in the best of times, it is unlikely to earn high enough returns to meet your goals.
Like many things in life, it’s a question of balance.
YOUR PREFERRED INVESTMENT JOURNEY
Q1. I/we expect my/our investment portfolio to:
a) give low returns
b) give modest
c) give solid returns
d) perform well, but
e) keep pace with
largely independent
returns with some
with some significant
not as well as the
the sharemarket.
of the sharemarket.
minor fluctuations.
swings along the way.
sharemarket.
Q2. I/we would expect my/our investment portfolio to show positive long-term returns, but can accept a downturn:
a) every 15 to 20 yrs
b) every 10 to 15 yrs
c) every 5 to 10 yrs
d) every 4 to 6 yrs
e) every 3 to 4 yrs
Q3. I/we could accept the following downturn in the overall value of my/our portfolio in any one year:
a) a 5% downturn
Farrelly’s
b) a 10% downturn
c) a 15% downturn
d) a 22% downturn
e) a 30% downturn
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The second approach to emotional risk profiling is to have the client complete a
scientific psychological risk tolerance assessment. Unfortunately, not all profilers in the
market can be described as scientifically valid. In fact, we see many profilers in the
market that can best be described as misguided attempts to measure some
combination of psychological risk tolerance and financial risk capacity (they’re the
ones that effectively are saying it is ok for the train to get to the station early, even
though you may not be on it when it arrives, or that it’s ok to get to the wrong station
as long as the journey was sufficiently comfortable). A scientific psychological risk
tolerance profiler will concentrate on questions concerning attitudes and
experiences. It should not contain questions that try to measure both psychological
risk tolerance and financial risk capacity at the same time. As stated earlier, these
two risk tolerances are quite separate and should be kept separate. Some sort of
crude average of the two is quite unhelpful.
An example of the unhelpful questionnaire is one where the investor is asked to fill out
a questionnaire that contains questions such as:

What is your age? 30-40, 40 -50, 50-60, 60-70, 70+

When will you retire? 10+ years, 5-10 years, 0-5 years, already retired

Are you generally conservative, aggressive, etc?
The first two questions have very little to do with the clients psychological risk
tolerance, and as questions about financial risk capacity they are extraordinary blunt
instruments. As all planners know, deferring retirement for two years can often
dramatically alter an individual’s financial situation and therefore their financial risk
capacity. This type of survey doesn’t even distinguish between one and five years to
retirement. Furthermore, it then mixes up the data collected on financial risk capacity
with the data on psychological risk tolerance, to generate a mixed score that lines up
with a model portfolio of some kind. This approach might be better than no attempt
at profiling, but it probably misses the mark more often that it hits it.
For an excellent discussion on the characteristics of a scientific risk profiling system,
you may wish to read Roszkowski, Davey and Grable’s “Insights from psychology and
psychometrics on measuring risk tolerance4”,or Michael Kitces in his short article “The
Promise of a Good Nights Sleep5” both of which are available on the farrelly’s website.
Once investors have agreed how much of a downturn they can accept we simply
estimate the level of short term risk inherent in any portfolio – this can be seen in the
Proactive Asset Allocation Handbook, or estimated using the Implementor software for
any portfolio.
STEP 4: FINDING A PORTFOLIO THAT SATISIFIES ALL THE INVESTOR’S CRITERIA
Having identified the investor’s goals, minimum requirements and ability to tolerate
downturns, we can now look for a portfolio that satisfies all three.
Farrelly’s
1.
It should be likely (with at least 50%probability) to achieve the return required
to meet the investor’s goals;
2.
It should be very likely (with at least 95% probability) to meet the investor’s
minimum cash flow requirements; and,
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3.
It should be unlikely (no more than 5% probability) to show short-term falls
much greater than the investor’s agreed tolerance for downside risk in any
one year.
WHAT HAPPENS WHEN NO PORTFOLIO MEETS ALL THE CRITERIA?
Unfortunately, this is all too often the case. Essentially, this means that the client will
not be able to meet their goals unless they make some changes to their plans.
Fortunately, there are plenty of levers to use to ensure their plans and investment
strategy are compatible:

They can increase their saving by reducing pre-retirement spending;

They can reduce their spending plans post retirement;

They can work longer;

They can plan to reduce their real spending levels over the course of their
retirement (that is, not index retirement spending to inflation);

They can plan to leave less in their estate;

They can accept the risk that their funds will run out early and they may have to
endure a much lower standard of living than they had planned.
Once the overall goals are in the achievable range, then understanding the investor’s
relative tolerances creates further opportunities for portfolio design. For example, if
psychological risk tolerance is the limiting factor then using direct fixed interest rather
than fixed interest funds, or using property syndicates rather than listed property can
reduce volatility without impacting long -term returns. If financial risk capacity is the
limiting factor, then it will be necessary to work on the planned levels of saving or
spending in order to get a satisfactory plan.
WHAT IF MANY PORTFOLIOS MEET THE CRITERIA?
On some occasions the opposite will be true, there are a number of different risk
profiles that will be acceptable to the client. Often this is where the client has very
high risk capacity – generally as a result of having more money than they know what
to do with, or, more accurately, more money than they need. In this case an investor
could absorb many years of poor returns without affecting their living standards. To
be sure theymay not be happy with their investment outcomes, but their cash flow
requirements will still be met.
If in this case the investor has the ability to emotionally cope with lots of short term
volatility then there will be a range of acceptable risk profiles for the investor; both a
low risk portfolio or a high risk portfolio are likely to get them where they need to go;
the challenge remains, how do you choose?
Or to put the question another way, is the role of the planner to maximize returns or to
minimize the risk that client goals are not met?
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THE BOTTOM LINE
When profiling investors, the key point to remember is that the purpose of the exercise
is to find a portfolio that will meet the client’s needs. Risks are the things that get in the
way of meeting those needs, be they risks that the investor’s needs won’t be met by
the strategy, or that the investor won’t be able to stay with the strategy.
We want to identify portfolios that will meet all of an investor’s criteria – that are very
likely to meet their primary goals, and that are unlikely to exceed their tolerance for
losses in the short term.
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Maximising returns or minimizing risk?
This is a non-trivial question that all planners should ask themselves; is their role to
maximize returns or minimize the risk that goals are not met?
Traditional planning philosophy puts planners in the role of return maximisers. The
argument goes like this.
History proves that in the long run equities will outperform fixed
interest and cash. Not may outperform, will outperform. That
being the case, the way to maximize returns is to encourage the
investor to invest the maximum they can bear in equities and
other growth assets. In the long term equity risk goes away
because equities always outperform, and therefore over time
cash is the risky asset.
Unfortunately there is a massive flaw in this argument. Rather than proving that
equities always outperform, history does quite the opposite; it proves that equities can
have very long periods of poor performance and in those periods they can be
dramatically outperformed by fixed interest and cash. Japanese investors understand
this well having suffered through a twenty year bearmarket. US investors are coming
to this realization as well – some 12 years after the 2000 peak the S&P500 is still almost
20% below its high point. The UK market as measured by the FTSE 100 is also well
below it’s 2000 peak, worst still, the NZ market is still well below its 1987 peak. Australia
is one of the very few markets where the myth of equity outperformance is still alive.
As soon as we accept that equity markets generally outperform other assets, but at
times underperform dramatically for long periods of time we realize that risk does not
go away over time and that a strategy that is more risky is, well, more risky.
At this point it becomes clear that maximizing returns or minimizing risk is a
philosophical choice that needs to be made. While ultimately the choice should be
made by the investor, that choice will be normally be heavily influenced by the
adviser. And so it is important that the adviser has a clear philosophy about their role.
An adviser whose philosophy was to minimize risk might communicate it as;
“My role is to understand the range of portfolios that could enable you to meet your
financial goals and help you choose the one that has the highest chance of meeting
those goals. Because this portfolio will have lower risk than other alternatives it will
often have lower expected returns.”
Should your goal be to maximize returns rather than maximise the chance a client
meets their goals you may describe your philosophy as;” I can help you identify the
portfolio with the highest expected returns that still has an acceptable level of risk.”
This will lead to quite different outcomes than the minimizing risk approach.
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This maximizing returns philosophy has been characterized, perhaps unfairly,
in this way;
“What is even more ironic, however, is that once we supposedly
identify an investor’s tolerance for risk, we then endeavor to position
them TO EXPERIENCE IT! This is like identifying that a person can “tolerate” a second-degree burn and then proceeding to place their hand
in a fire long enough to achieve it. Oh, by the way, in your attempt to
achieve a second-degree burn there is a 33% chance that you will
achieve a third-degree burn...so don’t try this at home.”
David Loeper, Rethinking Risk6.
Despite, farrelly’s obvious bias to the philosophy of maximizing the chance that
objectives are met, we do recognize that both approaches have validity. The critical
point is to recognize exactly what any advice process implies about underlying
philosophy and beliefs and to then ensure that those are consistent with the actual
beliefs held by the adviser. If there are inconsistencies, change the process.
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Appendices
A note on short term and long term risk measures used in the Handbook.
The Handbook describes long term and short term risks as 1 in 20 and 1 in 50 worst
case outcomes. It is important to understand exactly what we mean by this.
Long term risk is the chance that real returns will be below a certain level over the
next decade. Therefore a 1 in 20 worst case outcome of 1% pa real means that there
is a 1 in 20, or 5% chance that a portfolio will deliver returns less than 1% real over the
next decade. In other words the investor can be 95% confident that they will achieve
at least 1% real over the next decade. We think that is a sensible level of risk to take
with bare minimum outcomes.
A 1 in 50 worst case outcome is one where we have only a 2% assessed risk of a worse
result than that shown, or put another way, we can be 98% confident of getting a
better result.
We think that of the two the 95% or 1 in 20 confidence assessment represents a
sensible level of risk to plan for. As a result it is the risk level adopted by the Projector.
The short term risk measures are similar but with one important difference which is the
time frame of the assessment. The 1 in 20 worst case one year return is the probability
of getting that return in any one year. Now over a ten year period this probability
changes dramatically. Over a ten year period we effectively have had ten
opportunities to experience that 1 in 20 year event. Over a ten year period there is
about a 50% chance that we will see a fall of that magnitude, over a 20 year period it
becomes almost certain that we will experience a fall of that magnitude.
So when describing short term risks the 1 in 20 worst case outcome is one that every
long term investor should expect to experience at some time or another. In any one
year it is quite unlikely, over a longer period it becomes a virtual certainty.
The 1 in 50 year fall is a different kettle of fish. This is no certainty, but does represent a
realistic possibility. Falls of these magnitudes in equity markets did occur in 1929, 1974,
and of almost this level in 2009; as you would expect, every 40 to 50 years. They
represent something that is clearly possible, but no certainty, except in the very, very
long term.
Farrelly’s
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Bibliography
Each of the following papers is available on the subscriber-only farrelly’s Investment
Strategy Handbook Forum - go to http://www.portfolioconstruction.com.au/tools
Farrelly’s
1.
Farrelly, Tim, “Towards a Better Measure of Risk,” Portfolio Construction Journal,
Vol 1 No 2, Spring 2004.
2.
Bogle John P, “Investing in the 1990’s: Occam's Razor Revisited,” Journal of
Portfolio Management, Fall, 1991.
3.
Farrelly, Tim, “Avoiding avoidable mistakes”, working paper August 2010.
4.
Roszkowski, Davey and Grable’s “Insights from psychology and psychometrics
on measuring risk tolerance”, in the Journal of Financial Planning April 2005
5.
Michael Kitces, The Promise of a good nights sleep.
6.
David Loeper, Rethinking risk. .
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About farrelly’s
Tim Farrelly is Principal of farrelly's, Australia’s only specialist asset allocation
researcher. farrelly’s is dedicated to helping investment professionals design and
implement asset allocation philosophies and processes that are consistent their
beliefs and core strengths.
Tim brings to the task of asset allocation a unique combination of analytics,
understanding of financial markets, knowledge of capital market history and
insight into the practical requirements of investors and financial planners.
He is the author of the farrelly’s Proactive Asset Allocation Handbook and chairs
the Inquisitor Program at the Portfolio Construction Forum. Tim is a sought after
speaker and a frequent presenter at FPA annual and state conferences on a
range of topics including capital market history, risk management, and portfolio
construction.
Prior to founding farrelly's in 2003, Tim was an Executive Director of Macquarie
Bank Ltd, and Director of Macquarie Investment Management Ltd.(MIML) At
various times during his 14 years at Macquarie he sat on the MIML Asset
Allocation and Risk Committees, and was responsible for distribution of the Bank's
products through third party financial planners and stockbrokers. While at
Macquarie, Tim was responsible for the booklet 'Understanding Risk to Meet Your
Financial Goals', which is jointly published by Macquarie and the FPA and has
become an industry standard, and the Long Term Forecasting program in 2000
which foreshadowed the bearmarket in US equities.
Between 1981 and 1986 Tim was head of research for the Monitor Money
Corporation, where he was responsible for asset allocation and manager
selection.
Tim can be contacted at [email protected]
Farrelly’s
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