The study of “risk” in our financial world has been discussed for decades, and it has grown to encompass dozens of different opinions and methodologies. When it comes to understanding and measuring risk specifically within wealth management, recently things have really become complicated.
In his book “A Random Walk Down Wall Street”, the renowned Princeton economist and professor, Burton Malkiel said: “Risk is a most slippery and elusive concept. It’s hard for academic economists let alone investors to agree on a definition and to understand what it means.”
A Princeton professor of Economics when discussing the issue of defining a risk profile for clients suggested, that we may as well ask the client how many red blood cells he has in his system as in both cases he is aware of the concept but cannot comprehend the implications.
It is also completely clear that attempting to accumulate assets for retirement without exposure to some risk is almost futile, and the whole middle class in the community would fund themselves in an impossible situation.
It is customary for financial Professionals aligned with compliance directives to build each client a “Risk Profile” and then purchase suitable investments aligned with the profile, however, we question the value of this methodology.
The “Risk Profile” is an evaluation of an individual’s willingness, capacity, and ability to take on risks. A risk profile theoretically, therefore, is important for determining a proper investment asset allocation for a portfolio.
Controversially, it is accepted that if an individual expresses a desire for the highest possible return – and is willing to endure large swings in the value of the account to achieve it – this person would have a high willingness to take on risk and is a risk seeker. However, is it really clear to the investor that the risk the investor is taking is not achieving a high return over time with volatility in the process, but actually taking on the risk that he will in high probability expose himself to the possibility of losing all his money?
It is clear, that there are many challenges in the process, however, most investment houses and banks try to align themselves with a process that is compliant with the regulatory directives that require them to build a “Risk Profile” for every client, and then match suitable asset allocations and products to the client’s needs.
How do you create a “Risk Profile”?
It is customary to use a methodology of asking the potential investor questions. If this process is worthy then I ask, how many questions are sufficient? Is three enough or should we ask at least 10, or perhaps 100?
Dilemma No 1: who writes the questions? Do they have the backing of academic research? Who decides what kind of questions should be asked? Is there any sequence to the questions?
Dilemma No 2: who decides based on the answers received what the risk profile is? Let’s say that we define the risk profile as “10 being willing to take on the most risk and 1 being the most risk-averse”, then who decides that based on the questions asked, it would be fair to conclude that the individual should be categorized within this framework.
Dilemma No 3: who decides what products or what portfolio should be matched to each risk profile? Let’s say that we are categorized as a level 7 “Risk Profile” then who decides what funds, equities, or bonds should be in the allocation?
Dilemma No 4: can we really be categorized in a 1-10 system. Are all the families in category 5 in need of the same asset allocation? Do you all have similar family circumstances, life goals, challenges, and dreams? If not how can this system work?
Using stochastic modeling for building an asset allocation.
What is stochastic modeling?
Stochastic modeling is a form of financial modeling, that is used to help make investment decisions. This type of modeling forecasts the probability of various outcomes under different conditions, using random variables.
Stochastic modeling presents data and predicts outcomes that account for certain levels of unpredictability or randomness. Planners, analysts, and portfolio managers use stochastic modeling to manage client’s assets and optimize their portfolios.
The Stochastic analysis takes the data from the last 10 years (for example) of a specific asset or asset class and explores the volatility of the asset in hundreds of billions of scenarios. The result is a map of possibilities, that the asset should achieve over time and the probability of this happening.
The advantage of using this available tool is that, when discussing risk with families, the professional can add an additional dimension to the equation and talk about the probabilities of achieving a specific goal. In other words, if we define a goal such as a retirement at age 70 and we need to accumulate assets of let’s say $1,000,000, stochastic planning will deliver the range of possible outcomes and define the probability of achieving a goal.
The disadvantage of the tool is that it’s based on past results of each asset class, equity, or bond and as we all are aware the past is no indication of the future.
For example, stochastic planning will not consider the present yield to maturity for sovereign bonds which are negatively adjusted to inflation.
While all these tools are very important and the concept of taking responsibility, since managing clients’ financial destinies is a very important development, we need to improve on these methodologies to include the individuality of our investors and their specific life goals, dreams, values, and aspirations.