THURS, JAN 11th, 2018
Serious financial advisors regularly grapple with how to assess risk for each client and how to translate that assessment into investment portfolio construction. Financial technology software firms have created tools that allow clients to complete self-administered risk profile analyses rating their risk on a numeric scale. This automated approach falls short; it presents risk as two dimensional. Our experience over several decades points to risk being an oscillating multidimensional issue. We address client risk in three dimensions; risk capacity, risk tolerance, and risk perception. Of these dimensions, risk capacity, the objective, often mathematical, analysis of how much risk a particular client can afford to accept, is the easiest to assess.
The next dimension is risk tolerance; the ability of an investor to remain committed to a long-term investment plan. We work to quantify how volatile an individual’s investment plan can be without fear or greed causing them to exit the strategy. Investors rarely believe they exit investment plans for emotional reasons. Exits are almost always based on the belief that because of what markets are doing the current investment course is illogical; and market action typically supports this view! However this almost always means changing course at the wrong time. An accurate reading of risk tolerance aims to avoid this unsuccessful scenario.
Risk capacity and risk tolerance are often out of alignment. We work with risk averse families with tens of millions of dollars who spend as much as a typical middle class household. They have a high risk capacity but a low risk tolerance. On the other extreme are retirees who withdraw a substantial percentage of their portfolios each year to fund large living expenses. These clients are going to run out of money yet want an aggressive investment approach to forestall the inevitable. They have a low risk capacity but a high risk tolerance.
Finally, risk perception. This is the headline risk revolving around current events. For example, concerns that the election of a new president may ruin the economy, or, the risk that another mass shooting may cause consumer confidence to plummet and financial markets to collapse. Risk perception aims to understand the degree to which our clients react to what they read or see in the news.
Risk capacity usually remains fairly constant, barring a dramatic change in a client’s financial circumstances. However, the same cannot be said for risk tolerance and risk perception. Clients’ risk tolerance will vary based on recent experience. Clients who initially present as highly risk tolerant may change their tune and become more interested in stable, moderate returns. Perhaps in the interim a friend had a deal go bad or they realized their parents were not on as solid of financial footing as they had originally thought. We have found that it takes many conversations across time to truly understand how our clients feel about risk.
After exploring client risk, we then focus on drafting investment policy statements and constructing appropriate portfolios. At this stage we dive into another set of risks; those related to investments rather than specific to the client. We aim to help our clients better understand the risks associated with volatility, inflation, interest rates, and default.
Volatility is the risk that a given asset will be worth less tomorrow than it is today. Yet, it is also volatility that over time provides investors with positive returns. Volatility cuts both ways.
Another important factor is inflation risk; the risk that portfolio purchasing power will be less in three, five, or ten years’ time. Typically if a client is invested to minimize volatility risk they are, either consciously or unconsciously, accepting substantial inflation risk.
We also discuss interest rate risk and default risk. Interest rate risk is the risk of a client losing money due to an adverse move in interest rates. In today’s environment most investors would experience such losses if interest rates were to rise. Default risk is the risk that securities in the portfolio are unable to meet their contractual obligations. Default causes investors to receive less in principle and interest than expected.
To illustrate the interplay between the various forms of portfolio risk we created a triangle with the three apexes labeled ‘long term growth’, ‘income’ and ‘safety’. Every investment portfolio lies somewhere within this triangle and the specific placement reflects the tradeoff between variables.
A point on the line between long term growth and safety reflects a tradeoff between volatility risk (mitigated by safety) and inflation risk (mitigated by growth). A point on the line between safety and income reflects a desire for safety balanced against volatility, interest rate, and default risk accepted in order to generate income. And, between growth and income investors desire to minimize inflation risk while generating stable annual cash flows.
When crafting portfolios it’s useful to look beyond financial assets. In many cases our clients have assets in addition to their investment portfolios. They may be business owners or own commercial real estate; they may have concentrated stock, or stock options, of their employer. Our risk analysis is most effective when it encompasses all balance sheet assets. Clients with a substantial investment in a risky start-up should aim to offset that risk through an investment portfolio focused on safety. If clients own a stable real estate asset with highly predictable cash flows but not much growth potential then their investment assets might be more toward growth.
To better understand the risk tradeoffs built into your existing investment portfolios and how portfolio risk relates to your personal risk profile, please call Albion Financial Group’s Senior Wealth Advisors at (801) 487-3700.
John Bird, CFA®, CFP®, MBA / President, Principal and Co-Founder
Albion Financial Group