From Risk Tolerance to Proposal Generation

The result from the Risk Tolerance Test is the primary driver for asset allocation. If there are two people in the household, use the average.

The next step is to incorporate risk capacity, which is determined by the investment time horizon and cashflow considerations such as income stability.

You can use “auto assign” to assign an asset allocation using the simple algorithm below, or you can assign it manually.

• If the time horizon is 6-10 years, use the model portfolio chosen in the Risk Tolerance Test;
• More than 10 years, go up a step;
• 3-5 years, go down a step;
• Less than 3 years, go down two steps.

Note: If the client doesn’t need to take the risk to achieve their investment goals, they don’t have to take the risk. For example, assume that a client chooses a 60/40 portfolio in the Risk Tolerance Test and they have a long time horizon. If the return of a 40/60 portfolio is enough to achieve their investment goals, it is perfectly fine to go with a 40/60 portfolio.

The result from the Risk Tolerance Test, where the client explicitly chooses a model portfolio with the upside and downside tradeoff that they feel most comfortable with, should be the main driver for portfolio decision.

A common question is: how do we incorporate risk capacity and investment time horizon?

Risk tolerance indicates how much risk the investor wants to take, while risk capacity indicates how much risk they can afford to take. It makes sense to consider both when making portfolio decisions.

How do you measure risk capacity? A common misperception is that investors with more money (in relative to investment goals) have more risk capacity. This is not true.

• Investors with more money can afford to take the risk because they can absorb some loss, but they can also afford NOT to take the risk because they don’t need the extra return.
• Investors with less money can’t afford to lose money but they also NEED to take the risk because they need the extra return.

The true measure of risk capacity is the investment time horizon. If the investment has a long time horizon, it can afford to take the risk. Assume an investor chooses a 60/40 model portfolio in the Risk Tolerance Test, if they are in their 30s, you can go a step up to assign a 70/30 model for their retirement account; if they are in their 70s, you can go a step down to give them a 50/50 or 40/60 portfolio.

Rule of thumb

• If the investment time horizon is 6-10 years, stick with the chosen model in the Risk Tolerance Test.
• More than 10 years, go a step up,  i.e. take the next model with more risk in your model set.
• 3-5 yeas, go a step down.
• Less than 3 years, go two steps down.

Please also note that for the same investor, different accounts may have different time horizons. For example, someone in their 30s may have an account for the down payment for the house and a retirement account. The same principle applies at the account level.

One of the benefits of the Andes Wealth Platform is to allow each member of the household to have a risk profile and show them side by side. This will maximize client engagement.

If the spouses have different risk tolerance level, you can use the middle ground.

But it also depends on family dynamics. If the couple makes financial decisions together, the middle ground makes perfect sense. If one of them is the main point of contact for the advisor-client relationship, perhaps the preference of this person matters more.

You could also argue that the middle ground makes sense for joint accounts, while individual accounts (including retirement accounts) should observe the preference of the account owner. However, if they are going to spend their retirement life together, one person’s retirement account does impact the other, hence it still makes sense to build in some compromise as a courtesy to each other.

If a client in their 30s chooses a conservative portfolio for their retirement account, the best way to convince them to go one or two steps up is to show them the “Growth of $1” chart over a long time period, which illustrates what they miss out by not taking the risk.

If a client chooses an aggressive portfolio for investments with short time horizon, the best way to convince them to go a step down is to show them the drawdown chart (peak to trough decline), and the “Growth of $1” over a shorter time period that includes a down turn, so they will see how much money they could lose.

The upside and downside are two sides of the same coin, and you want to make sure you cover both sides of the story. Even when you try to convince clients to go a step up, you want to explain to them the loss that might occur in the short term, and ask for their pre-commitment to stay on course.