Reducing risk

Risk tolerance is something many investment firms have routinely overlooked. But ravaged by recession, they are desperately looking for ways to create a better risk model. AER spoke with Meir Statman, the Glenn Klimek Professor of Finance at the Leavey School of Business at Santa Clara University in California, and one of the world’s foremost experts on behavioural finance, about topics ranging from his research study, which he recently co-authored with Nobel Laureate Henry Markowitz, to his theory about enhancing the portfolio construction process, and creating a model that does a better job of meeting the real risk tolerance of investors.

Q: What are investors thinking right now? A: If Nouriel Roubini could see it coming, why couldn’t my advisor? Investors are losing some of their trust in their advisors’ abilities. To compound things, we’re seeing multibillion- dollar scandals such as the Madoff Ponzi scheme and now the Stanford group.

Managing market turmoil fuels non-traditional approaches to managing investment risk. It’s a difficult situation for clients who don’t have advisors. The January issue of the Journal of Financial Planning asked: Is Markowitz wrong? The story sported a young man with a bewildered look on his face. That really is where we are now.

Q: Is Markowitz wrong? A: No. Markowitz isn’t wrong at all. If you look at 2008 and ask yourself: What’s the difference between U.S. stocks and international stocks? The answer is: Developed markets other than the U.S. went down something like 45% to 46%; the U.S. went down 39%.

The point that matters is the differential between the U.S. and international stocks was about seven percentage points—700 basis points. Investors who failed to diversify by putting all their equity money in developed markets other than the United States, would have been in much better shape.

What diversification does is help us. But the theory that diversification eliminates risk altogether has been tested during this downturn. Diversification did help, but many of us had exaggerated expectations from it. You promised diversification would insulate them from risk and it didn’t. So it’s important advisors explain to clients what diversification does and doesn’t do.

If you want to really cushion yourself, you need to cut down on your exposure to equities and buy more bonds. That also means you won’t grow rich—which is too bad—but that’s life.

Q: Some money managers say too much fear is priced into the market. Market conditions aren’t rational based on fundamental indicators. Do you think that’s the case? A: It might be. If you look at previous Gallup surveys, in February of 2000—pretty much at the peak of the market—they asked: “Is this a good time to invest in financial markets?” About 72% of the respondents said yes. In March of 2003, when the market was very low, they asked the same question, and only 41% of the respondents answered in the positive.

But then, after February of 2000 the markets went down. In February of 2003 they went up. I think it’s fair to say people are more frightened than is justified. Judging by history, when investors are at their most fearful, markets most likely rise. That’s like saying if people are afraid there’s a 52% to 48% chance markets will do well. But 52% to 48% are good odds if you’re gambling in the casino— if you have to put up your retirement savings, given those odds, there’s a 48% chance you’re going to be dead.

Q: What’s the investors’ frame of mind as far as financial planning objectives go? When is it okay for an advisor to step in and say: “You’re being irrational?” A: Advisors shouldn’t say everything’s going to be fine, unless they’re willing to vouch that if the value of the portfolio goes down they’ll make it up from their own pocket.

They need to put themselves in the investor’s shoes. If the advisor’s been with a client for a number of years, in all likelihood he’ll recommend a portfolio that’s roughly 70% equities and 30% fixed income—or maybe 60/40. In addition, he’d most likely recommend stocks for the long run.

Clients come back and blame advisors for recommending equities that have done poorly. They’re not justified in doing that, but it’s a natural thing to do. Like most people, clients are influenced by hindsight. They feel regret and look for somebody to blame. Advisors need to look at realistic goals of the client. Let’s say, there’s a client aged 65, with a wife the same age. They have $1 million in their portfolio. That money would buy them an immediate annuity—that isn’t linked to inflation—and that pays around $57,000 a year for the rest of their lives.

As a financial advisor, you have to ask yourself what this client is going to get from social security, pension, and other sources of income, including continued employment. How much more will they need for a decent lifestyle? Instead of doubling up on equities, the advisor might want to put some money into fixed income such as immediate annuity, just to make sure the client isn’t poor.

We all want two things in life: One is to be rich, the other is not to be poor. Not being poor is more important than being rich. If people didn’t realize that before, they certainly understand it now. I think the primary responsibility of advisors is to protect the downside of their clients’ portfolio.

Q: On the flip side, how should advisors manage clients during periods of exuberance? A. On the upside, advisors should make sure their clients’ downside is protected before they jump to the upside. If there’s excess cash, gamble thoughtfully—don’t buy lottery tickets—equity mutual funds are fine. Advisors should tell clients markets behave irrationally both when the consumer sentiment is fearful and when it’s exuberant.

Q: In what sense does a behavioural approach modify what we have taken for granted from modern portfolio theory? A: A portfolio is not one big block. There’s money you need to leave for retirement, there’s money you hope to leave for your kids, there’s money you want to direct toward your grandkids’ college education, or toward supporting a disabled child. People have all kinds of goals.

I co-wrote a paper, “Portfolio Optimization with Mental Accounts,” with Nobel Laureate Harry Markowitz and a couple of other colleagues, which integrates elements from behavioural portfolio theory.

In the paper, we began with a pot of money an investor has. What happens if that investor begins by specifying goals, such as retirement, education for a grandkid, bequests etc? How much money would be devoted to each? What kind of money would be left by the end of it? Bequests might be 30 years away. College education might be three years away and so on.

Suppose an investor treats each of those buckets within the account as a sole portfolio and optimizes it in the usual mean variance form. What would those portfolios look like, and are they on an efficient frontier? In other words, if you do your portfolios one at a time rather than as a whole, do you lose any of your efficiency? The surprising answer is you don’t. Under some special conditions you might lose a bit, but generally there’s no loss of efficiency.

Here’s an example of a nice combination of the usual mean variance framework with behavioural finance, which specifies how we can provide a normal investor, who thinks of that money as belonging to different buckets, and create portfolios that help that investor visualize goals without losing anything in terms of efficiency.

Q: Do all of these buckets share the same time horizon? A: No, they don’t. The time horizon for a client who’s 65—assuming he’s going to live to be 95—is 30 years. Let’s assume the client wishes to retire at 70, and save for his grandkids’ education. You can tailor each bucket to each of those time horizons. Based on his risk aversion, the usual approach right now is a 60/40 stocks and fixed income portfolio. If the market tanked, the portfolio might change to 70% fixed income and 30% equities, so you’d want to increase the portion of equities. Advisors will say: “In this market you should really buy more.” Of course investors would say: Are you out of your mind?

Let’s say you created that portfolio in October of 2007, when times were still relatively good. There’s a 95% chance the client’s going to hit his retirement goal. There’s a 70% chance he’s going to meet the education (for the grandkid) goal, and there’s a 30% chance he’s going to meet his bequest goal.

Now when you look at it as different buckets, you realize the bequest bucket has been shattered. The likelihood of achieving that goal is 5%, the likelihood of the college education goal might now be 50%, not 70%. But if you timed it right, the client’s retirement account is 95%. This can create a much better conversation between the advisor and the client, where you can assure the client the real important things are still fine: “Some of your inspirational goals have received a setback. But if you’re lucky these are going to be remedied in the future. If not, you at least have downside protection.”

Q: Does the same type of risk aversion underlie each bucket? A: No, absolutely not—that’s exactly the point. Let’s say your client wants to leave a million dollars to his alma mater, but he isn’t one of those super rich people for whom a million means nothing. But he does have $100,000 he can set aside. If he’s really lucky, by the time he dies, it might grow to a million dollars. For this bucket, I’d be willing to take an aggressive stance. It’s great if it works out, too bad if it doesn’t. But if it were a retirement account, I wouldn’t put a $100,000 in and hope against hope it’d make me a million. I’d want to be very conservative. So, your attitude toward risk varies with the goal.

Q: If you add all those risk aversions together, can you construct a homogeneous risk aversion? A You can infer from the overall portfolio what the global risk aversion would be. Global risk aversion is not a simple average, or a simple weighted average of the individual risk aversion coefficient. If an investor has three separate risk aversions, he’ll have one risk aversion that’s a combination of all three.

Suppose I offer my client a portfolio to either increase his standard of living by 50% or decrease it by x-percent. What is the maximum risk he’s willing to take to increase his standard of living by 50%? The typical answer, we found, is about 12%.

People expect at least a 4 to 1 ratio—50 to 12, between upside and downside. People are pretty risk-averse.

Q: Have you created a template that uses appropriate questions and correlates what types of asset allocations should be established? A: I haven’t created a full-fledged questionnaire, but I do have a table that can do that.

There are also some specific questions I ask. For example, “Do you think you’re a betterthan- average stock picker?”

It turns out people who end up saying they can pick out stocks better than average are overcon- fident. And you end up wondering when somebody says they can take risk, is it because they can take risk or is it because they are stupid enough to believe they have superior stock-picking abilities and are in fact overconfident? Essentially, they think there is no risk. That can happen in periods of exuberance when clients might think there’s no risk, so what’s there to be adverse about?

Q: Can you name some of the different investor temperaments? A: There are four broad categories:

› Guardians: They are typically managers; good at logistics and scheduling; detail-oriented, and prone to taking care of things in business. Profession-wise, they make good policemen or auditors. They like order in their life. For guardians, saving isn’t difficult at all. They don’t have trouble giving up the pleasure of buying a new television, because they get more pleasure knowing there’s money in the bank. If your client is a guardian, chances are he’ll be adverse to risk.

› Artisans: They tend to be the entrepreneurs or even artists. Unlike guardians, they tend to live for today. They don’t plan as well for the future, and find saving very difficult. Artisans are more willing to take risk.

› Rationals: These are the clients most willing to take risk. They are scientists or engineers who think of things as systems, whether biological, or computer systems. They are theoreticians who like to know how the world works. The downside is they tend to be overconfident. They view the stock market as a machine or an engine that can be taken apart and put together again. Rationals also tend to find all kinds of convoluted ways of making money. In the process, they are willing to take larger amounts of risks.

› Idealists: In terms of risk aversion, these clients are just one notch below the guardians. Professionally, they tend to be teachers and social workers. If you think of an extremely rational person it’s an autistic man— somebody very good at arranging things and making sense of things but awkward socially. Idealists are the other side, they are the people who hate math, but are good at being empathetic. They’re more emotional. For Idealists, money really isn’t something to focus on—they aren’t maximizers at all—they’ll dip into their savings to give to charity. They’re more cautious and risk-averse. While no maximizers, they do view money as a means to do the stuff they want to do.