By Miles Clyne
If you’re an investor, you’ve likely been asked to complete a risk tolerance questionnaire to assist in determining a suitable investment strategy for you. Some questionnaires are solely intended to assess a client’s psychological predisposition toward risk, while other questionnaires go a step further and try to place a client into a particular fund or portfolio. We generally feel that there are a lot of considerations that should be discussed directly with the client before recommending a portfolio.
Generally, there are at least four aspects that make up an investors risk profile:
(1) the investor’s risk tolerance on the day they complete the questionnaire,
(2) financial capacity for risk,
(3) the need for risk, and
(4) the level of understanding and education the investor has regarding risk.
Most risk tolerance questionnaires try and satisfy the first aspect, while the remaining aspects should be assessed by way of detailed discussions.
For example, an investor with a high risk tolerance but low financial capacity for risk may need to consider a more conservative portfolio than the risk tolerance might indicate. Similarly, an investor with a very low risk tolerance that has the financial capacity for some risk and desire for better returns may be better suited for a portfolio that entails more risk than the client’s risk tolerance would indicate. In the current environment, if clients want a low risk portfolio, they should expect returns in the 1% - 3% range. Clients who wish the potential to achieve higher rates of return will need to hold some investments that are considered moderate or perhaps even high risk investments.
It is very important for investors to realize that the investment landscape is always evolving. Today’s landscape is very different from five, 10- and 20-years ago.
A once easy, low risk way, of making money has changed. Review this chart, called Rolling the Dice, to see how much this changed has affected investors.
What the chart highlights is that about 20 years ago you could generate a 7.5% rate of return owning 100% bonds. Fast forward 20 years, and assuming you wanted the same return, your portfolio would look very differently. Your bonds are now down from 100% of your portfolio to 12%, and the amount of risk (measured in standard deviation) has increased about three fold.
The conservative investor in 1995, who bought bonds because the 7.5% return fit their investments needs, would now have to take on substantially more risk to potentially generate the same return today. Typically, the right solution is somewhere in the middle. Today’s investors may need to reduce their return expectations, and perhaps take on a bit more risk than in the past. So, the 7.5% low risk portfolio from 20-years ago might be a 5.5% low-moderate risk portfolio today.
Most of us need an intelligent discussion and education on risk. Risk tolerance questionnaires are designed to place clients in a variety of general risk categories, which serves as a good starting point to launch into a discussion about other aspects of risk. Sometimes, what you want and what you need are not the same. It is the information that bridges this gap that is key to selecting an appropriate and suitable investment portfolio.