In my conversation with Greg Davies of Centapse, he has specifically talked about anxiety-adjusted returns as opposed to risk-adjusted returns. Advisers also talk a lot about risk tolerance and capacity for loss and attitude to risk.
This series starts with part one, here.
Answers to risk questionnaires or results from an algorithm are just a starting point. An adviser needs to be able to pick up on subtle clues, and I’ve got better at it over time, so I can guess what someone will do, given a set of circumstances. I asked Greg if we need to revisit the definitions of risk – balanced, cautious – in light of what he’s talked about, to find something less inadequate.
Greg doesn’t feel that we need to revisit the definitions, but we should be using them effectively. For him, risk tolerance is about long-term willingness to trade off risk and return over the whole portfolio. In a goals-based world, your risk tolerance is your willingness not to achieve a marginally more important goal for the chance of receiving that, plus a bit extra. It’s about taking a chance on a drop-in lifestyle to get something more.
The ‘right' portfolio
That leads on to: ‘What is the right answer for my financial needs?’ which is where the traditional framework comes in around risk tolerance and maps to an allocation that gives the right long-term risk/return trade-off.
All of this disregards the emotional responses along the journey. For instance, I could be in the right portfolio for my long-term financial needs, but it makes me so uncomfortable that along the way I start deviating from it.
The technically right portfolio is not necessarily the actually right portfolio, because it hasn’t taken into account me as a person and my tendency to change my mind or be too passive or aggressive along the way.
One of the first things Greg designed at Barclays was a financial personality assessment, a psychometric questionnaire built using data from 4,000 people around the world.
“Crucially, it includes a test for risk tolerance which we know is stable and does the right thing. We’ve got data on very turbulent times in markets, so we know it’s a good measure of risk tolerance, but it’s only the starting point. In the financial personality assessment are five other measures of personality, none of which have any place in classical economic theory, because the only aspect of personality taken into account there is risk tolerance.
“These five measures all tell us something about the way in which the individual client is likely to feel discomfited along the investment journey. By knowing that in advance, I’m able to change the solution. I don’t need to say: ‘Here’s your risk tolerance, it maps to a balanced portfolio, this is your asset allocation and now it’s your problem.’
“Instead I can say: Yes, this is the right portfolio for your financial needs, but to pick one example from the five, your composure score is extremely low. What that means is, despite this being right for your long-term risk tolerance, you are likely to be a particularly jittery person in the markets, and if I give you the balanced portfolio that’s right for your financial needs, you may actually end up worse off and unable to stick with it. Typically, what will happen is your decision not to stick with it won’t happen when things are going well – you’ll be selling at the bottom.
The best realisable outcome
“It should be my responsibility as an adviser not to just give you the technically right answer but to give you the answer that I believe will get you in reality to the best realisable outcome. I need to provide you with the beeswax, like Ulysses and his sailors used (read part two of this series to understand the analogy!)
“If I’ve used risk tolerance and their composure level, I can dial down the risk slightly to make it a more comfortable ride. Or, I can seek to buy downside protection to make sure they’re protected against the worst downturns in the market.
“More importantly, I can change the way I communicate with you over time, because I know that you have these tendencies. If I know that the markets or your portfolio is dropping, I’ll pick up the phone and call you first, because you are the person who needs talking off the ledge.”