Build a better risk profile

Innovative research in the field of behavioural finance suggests the investment industry may have misjudged the risk tolerance of well-off investors.

Meir Statman, the Glenn Klimek Professor of Finance at the Leavey School of Business at Santa Clara University in California, is one of the world’s foremost experts on behavioural finance as it relates to constructing personal portfolios. His research focuses not so much on how you can build the best portfolio in terms of performance but on how you can build portfolios that best meet an investors’ specific, psychological needs.

Many behavioural finance experts will use psychology to argue against the fundamental teachings of investing, saying human behaviour is the cause of market inefficiency.

Because each person has different goals — and very different risk attitudes toward each — he says there is a tendency for a person to try and average out the risk “in some way that has no feel or intuition to it. [They’ll] give you an answer, but that answer will most likely be nonsense.”

Statman’s research has determined that investor risk tolerance is, on average, extremely low.

“We all want two things in life: one is to be rich, and the other is to not be poor,” he says. “[For most people,] not being poor is more important than being rich. If people didn’t realize that before, they certainly understand this now. I think the primary responsibility of advisors is to protect the downside of their client’s portfolio.”

In a study he’s conducted, Statman says he asked clients what maximum risks they’re willing to take to increase their standard of living by 50%. He found the typical answer is about 12%.

His research found you can create individual, self-contained portfolios for each goal, each with its own risk profile. Cumulatively, the total portfolio made up of the individual portfolios will lose very little efficiency if each bucket is created following the tenets of modern portfolio theory.

Statman explains the concept, using an example in which a 65-year-old investor intends to be fully retired at age 70. Retirement income is his most important goal. Most likely, you would want to have a near bulletproof bucket for this goal, which has only a five-year time horizon. Other goals, such as bequests to charity, etc., could be put into riskier assets.

Statman says to create these buckets also requires doing a much deeper behavioural probe. For example, one of the things he wants to determine is whether an investor is overconfident, rather than risk averse.

“When somebody says they can take risk in a questionnaire, is it because they can take risk, or is it because they believe they have superior stock-picking abilities and are therefore overconfident? That can happen in periods of exuberance. Investors think they are geniuses, that there are no risks; what’s to be averse to?”

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.