What is risk tolerance?
Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision. Several factors determine the level of risk an investor can afford to take. Knowing the risk tolerance level helps investors plan their entire portfolio and will drive how they invest. For example, if an individual’s risk tolerance is low, investments will be made conservatively and will include more low-risk investments and less high-risk investments.
How does risk tolerance tools work?
Some tools ask investors to choose an upside/downside tradeoff, which is good, but the tradeoffs presented to investors are artificial, not real, in that they don’t reflect the models used by financial advisors. If the end goal is to assign a model portfolio to the client, why don’t we show the gains and losses of the advisor’s models and ask the client to pick the tradeoff that they feel most comfortable with? This way, the client’s choice maps directly to the advisor’s models. This is the approach our Founder and CEO Helen Yang take.
In this figure below, an investor picks a tradeoff that they feel most comfortable with then it maps directly to one of the advisor’s models.
It is direct, transparent, and defensible. The investor explicitly says that they feel comfortable with potentially losing 7.4% in six months in a relatively normal market condition, as indicated by the 80% confidence interval.
In the figure above the range of gain and loss for the chosen model 60/40 were calculated based on a target return of 6.80% and target volatility of 11.90. It assumed a normal distribution and an 80% confidence interval, i.e., in a relatively normal market condition.
Normal Distribution
While here in Figure 2, it shows the normal distribution, telling us that the chance is highest around the mean (i.e., average), which is the target return (6.8% in this case), or equivalently, 3.4% for six months.
Telling the Long Term Story
Now, telling the long term story – Figure 3 will show how the return of the 60/40 portfolio can vary greatly from year to year, but if you look at longer time periods, the outcomes become more and more certain. If the investor has a 10-year or longer time horizon, they don’t have to worry about the fluctuations from year to year.
But, we can also see both sides of the coin in the Figure 4 below:
Figure 4, the drawdown chart, shows how the 60/40 portfolio has a much smaller drawdown compared to S&P 500, offering protection in down markets.
If a client chooses an aggressive portfolio, this chart will encourage them to think twice. If they confirm that they are indeed fine with, say, a 50% drawdown, this information will be captured in the investment policy statement, which they will sign.
While in Figure 5, the Growth of $1, this tells the story that a 60/40 portfolio, while offering protection in a down market, doesn’t provide the same growth opportunity.
Summary
Risk tolerance assessment is a cornerstone in wealth management. Getting it right ensures appropriate asset allocation that matches the client’s risk appetite and financial circumstances.
More importantly, by having robust conversations about risk and reward, and documenting it in the investment policy statement, advisors can set expectations and tell a compelling long-term story, which will prevent problems during market turmoil.
Read the full article on Advisor Perspectives.
