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Transcript
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 Page 2 of 22 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 Page 3 of 22 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 Page 4 of 22 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 Page 5 of 22 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 Page 6 of 22 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 Page 7 of 22 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 Page 8 of 22 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; Page 9 of 22 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 Page 10 of 22 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 Page 11 of 22 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 Page 12 of 22 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 Page 13 of 22 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 Page 14 of 22 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, Page 15 of 22 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? Farrelly’s Page 16 of 22 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. Farrelly’s Page 17 of 22 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. Farrelly’s Page 18 of 22 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. Farrelly’s Page 19 of 22 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 Page 20 of 22 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. . Page 21 of 22 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 Page 22 of 22