Market Analysis: New form of risk profile can build a better portfolio

By 26/06/2017

Market Analysis: New form of risk profile can build a better portfolio

The challenge any investor faces lies in balancing the need for investment security against an optimistic outlook on returns. The level of risk that an investor is willing to take is what defines his/her risk tolerance or risk appetite. While investment risk is broadly understood by investors, and risk tolerance can be worked out to a computed number, it remains largely subjective in nature, chiefly because of the approach and the way the inputs are collected.

Financial advisers often define their clients’ risk tolerance via risk tolerance questionnaires emphasising the emotional capacity to lose money. This is part of an assessment of the ability (quantitative assessment) to tolerate risk in addition to the willingness (qualitative assessment) to tolerate risk. The outcome then is whatever the strategic asset allocation (that is consistent with the capacity for risk) will be expected to deliver.

New-generation risk profile tools have shifted away from traditional methods of measuring investors’ impact on potential losses and have helped get a deeper understanding into their sensitivities. But even these tools are based on abstract scenarios. It is probably fair to say that a person’s thought process will differ substantially between a hypothetical financial scenario and specific financial needs or events to avoid. In reality, an individual’s investment capacity and risk appetite at any given time is situational and circumstantial. And as variables change, not just with the economy but also with the individual, needs and priorities change.

Goal tolerance is the process of establishing a client’s appetite for variation to specific financial goals. The output from this can then be used to establish an appropriate portfolio. Placing a greater emphasis on clients’ goals (short-term versus long-term) and incorporating this into their risk tolerance level can produce higher levels of engagement between clients and adviser and offer a more accurate indicator to investor needs. This suggests that a benefit of a goals-based approach is that the investor is more likely to stick to the adviser’s recommendation and less likely to abandon it at inopportune times. We believe that the next generation of tools, advice platforms and planning strategies will be driven through a deep understanding of each investor’s ‘goal tolerance’.

Advisers can benefit from investors attaching tolerance levels to specific goals, ie a better connection as the investor feels that the adviser has a better understanding of their specific needs. Importantly, goal tolerance is not a one-time exercise but provides a framework for continued monitoring of an investor’s portfolio.

An effective adviser-client relationship will be established when the adviser is capable of fine-tuning the portfolio to align with a shift in the client’s priorities, goals achieved and discarded, or a change in other relevant circumstances. As an individual transitions through various levels of prosperity (subsistence, comfort, luxuries), his/her financial goals and tolerance for variability with respect to personal goals change.

For example, high-net worth investors with significant levels of discretionary income and assets are likely to have greater levels of tolerance to variations in the income needed to fund activities of their highest level lifestyle goals.

Risk tolerance also changes over time depending upon several factors including age, family situation, accumulated assets, level of spending and goals. For example, a young unmarried investor may opt for a different retirement income plan compared to a married retiree opting for a joint life pension payout. In the latter case, the married retiree’s goal lies within a preference to safeguard the spouse’s future rather than to receive a higher benefit while alive. The previous tolerance while young, single and spendthrift was aligned with producing income to achieve one set of goals.

With time and changing circumstances, the tolerance changes and those funds will be directed towards new goals which are now more important.

This highlights the active role required by advisers to assist their clients through a goal-based approach in assessing risk tolerance, creating a customised portfolio and judging whether that portfolio matches the client’s needs.

The science of measuring risk tolerance – and in particular goal tolerance – is still in its infancy and evolving rapidly. A goal tolerance assessment will assist advisers in engaging their clients, coaching them appropriately and enhancing their investing experience.

Danny Quant is a principal and consulting actuary in Milliman’s Singapore office. Simon Herborn is a consulting actuary in Milliman’s Dubai office. Milliman is a member of The Gulf Bond and Sukuk Association.