A third dimension of risk

None of us can deliver double-digit returns every year. What we can control, and what much of the industry’s compliance and support structures have focused on, is the risk within client portfolios.

In a world of emotionless clients who never panic over market shocks, asset allocation would be easy. We would put all long-term funds into diversified equity portfolios and all short-term funds into fixed-income products that would mature at the exact time and face values needed to cover expenses.

But clients are not robots. Each has her own ever-evolving risk tolerance.

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The industry attempts to quantify this tolerance along the dimensions of willingness and ability to bear risk.

As clients age, their risk questionnaire responses become more conservative.

Naturally, we have to reduce the risk in their portfolios accordingly, but we’re often met with resistance, likely due to behavioural biases. The solution? Consider the third dimension of risk.

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The first two dimensions

The first dimension, willingness to accept risk, is largely focused on a client’s psychological restrictions. This is captured through situational analysis. You ask, “How would you react to a drop in the market of x%? Would you be comfortable with a portfolio that returned x% if there was a y upside and z downside? How did you react in 2008?”

These questions help clients understand the tradeoffs of risk and return, and help you discover a client’s maximum risk tolerance.

The second dimension, ability, focuses more on a client’s personal situation and timeline. Questions include: Do you need the funds in the near term for a large purchase? Is your wealth relatively large or small when compared to your lifestyle expenditures? What is your current need for income?

The objective? To find out whether a client has a long enough timeline to absorb market shocks.Then, you allocate portfolios along the efficient frontier according to risk tolerance and return expectations.

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Resistance to change

Years pass. The portfolio you selected has hopefully performed as promised. Now, it’s time to revisit the suitability of this allocation because the client’s life circumstances have changed. In our reviews, we sit down with our clients, ask them to fill out questionnaires again, and explain why we should be changing the allocation. In most cases this goes well, but in some cases, the client resists. Why?

Behavioural finance experts suggest there are two reasons: status quo bias and regret aversion bias. Status quo bias says people don’t like changing previously made decisions. Regret aversion bias is fear of making a decision that makes you worse off than before.

When you talk about increasing the percentage of bonds to lower volatility and deliver income, the client hears “lower return.” Why would they want to make less? What if the current portfolio does better? And how do you help these clients?

Read: Help clients set realistic expectations

The third dimension

The solution is something my team and I do with all financial plans: a sensitivity analysis. It projects a client’s nest egg and compares it against target lifestyle expenditures in retirement.

Then, we use three different levels of return (3%, 5% and 6%) to see if the client’s nest egg is large enough to support him to age 95. Almost every plan we’ve put together works with a 5% rate of return; in more than half of cases, the plan worked with 3% return.

Even clients with status quo and regret aversion bias are assured by the revelation that they have enough money for the rest of their lives, even at 3% to 5% return. We then work backward to determine the most conservative allocation capable of delivering the minimum required rate of return and determine its corresponding risk level. In doing so, we have effectively identified the third dimension of risk: Minimum Risk Need.

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After showing them these results, we discuss the implications for asset allocation.

Risk tolerance range

When minimum risk need is considered in combination with maximum risk tolerance, it creates the risk tolerance range: the range of suitable portfolios a client’s comfortable with.

For instance, a client’s current exposure may be 70% equity and 30% fixed income, but she could achieve her target lifestyle with 20% equity and 80% fixed income. Once we explain that, she becomes amenable to a more conservative allocation. The conversation has become about giving up risk, not about giving up return.

All this does is flip the minimum rate of return into a risk metric, but what makes it effective is how we’ve reframed it for clients.