The use of risk profiling and model portfolios over the past couple of years has been incredible and it is understandable why. Risk profiling is a good start in the process of moving clients towards ‘outcome’ orientated solutions rather than relying on quartile performance and DIY portfolios. I often compare them to an automatic pilot, helping the pilot (or fund manager) reach their destination.
For example, risk-profiling software tends to look at the long-term when calculating the resultant asset allocation and this should make clients less concerned about the short-term volatility in the markets. Using the pilot example, this is all about knowing the co-ordinates to allow you to get from start to finish and knowing how long it is going to take to get there. If you are not willing to take risk, you will not be rewarded and those life goals are unlikely to be met. It is like being afraid of flying but wanting to visit the Caribbean.
The characteristics of the fixed income, alternatives, property, cash and equity markets are all different, and being able to diversify a portfolio across these asset classes makes sense.
Having clients fully on-board in relation to risk is great. They need to know the ups and downs of the different assets classes, the income potential and the correlations, but most importantly they need to understand that they are part of the process. They need to accept that at all stages of the investment cycle certain assets (either within or outside their portfolio) are doing better. Among the thousands of fund managers that I have interviewed, I have yet to find one that is first quartile over every time period, so it is fairly safe to say that being 100 per cent invested when markets are rising and 100 per cent cash when markets are falling is just a pipe dream.
‘Risk’ is an incredibly subjective word and should not be looked at in isolation. Most people would look at standard deviation as a guide to judge the volatility of the returns of a particular asset or asset class, and this is the measure that most risk-profiling tools use to help define the asset allocation. But standard deviation can change quite dramatically depending on your time horizon. We all are aware that over the long run normality reigns but in the short term markets can be incredibly volatile. I am sure we have all been on a flight and suffered a touch of turbulence.
Risk-profiling tools help define the asset allocations used to meet long-term objectives but do not take short-term market movements into consideration. Therefore, there can be long periods when certain assets can underperform. Continuing to invest in underperforming assets takes nerves and given time you should be rewarded. After all, the objective is to match a client’s long-term risk and reward profile.
Many take the prescribed asset allocation and overweight or underweight funds and sectors in the belief they can add value, while unwittingly creating drift and potentially changing the risk level. If a pilot sets off on a flight at 27.00 degrees, when he should have been at 27.10, for a short time you would not know the difference but as time progresses that 0.10 results in a very different position to that intended. If you adopt risk profilers, shouldn’t you almost slavishly follow the asset allocation and align short, medium and longer term interests?
Richard Philbin is a partner at Hasley Investment Management