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The efficient frontier spirit

The importance of risk profiling and asset allocation to financial advisers has grown considerably in recent years. This is due in no small part to the decline in guaranteed products – particularly with-profits, which historically combined the benefits of equity investment and safety.

This ability for investors to have their cake and eat it meant that investment and asset allocation often received little attention.

But there is now a need for an adviser to focus on a customer’s attitude to risk (ATR) to understand the preferred balance between equity investment and safer options such as fixed interest and cash investment.

Many advisers pay a lot of attention to determining a client’s ATR and have developed views about 1: the types of questionnaire, and 2: the balance of questions to use (for example, investment experience and knowledge v psychometric profiling).

Much academic work is also being undertaken on behavioural finance to understand investors’ motivations and patterns in decision-making.

In short, a lot of time, energy and science is being applied to try to get an accurate fix on an investor’s attitude to investment risk.

But once a client’s ATR has been determined, the rigour and science is often abandoned during the next stage of building a suitable portfolio. The sophistication can evaporate when it comes to the investment recommendation. This is apparent from the wide range of views on what is suitable for an investor with a particular ATR.

How, in practice, do advisers know that the portfolio they are recommending is suitable for a client who has, for example, been identified as a cautious investor?

It is quite common to find that one adviser’s recommendation for a balanced investor is another’s recommendation for a cautious investor.

Even more concerning, however, is that the client generally has no idea what to expect from the recommended portfolio.

This, in a world of treating customers fairly, is a serious shortcoming.

Risk – what risk?

Typically, an adviser will have a number of asset allocations designated to the different risk categories – one for the cautious investor, another for the balanced investor.

A number of questions, however, are typically overlooked. These include:

l How are these asset allocations determined?

l How are they mapped to the ATR profiles?

l What does risk really mean? It could mean, for example, risk of capital loss. It could also refer to a threshold, for example, “I really need a retirement income of at least £10,000 a year.” Or it could be the amount of variation in the outcome at retirement. It could also include the effect of inflation. In short, there are many possible definitions of risk.

Despite this range of definitions of risk, the default definition assumed is annual volatility. But does annual volatility of returns have any meaning or relevance to the investor?

Should asset allocation vary by investment goal?

How does the investor define cautious or balanced?

How does the investor definition relate to the models assumed in the ATR questionnaire?

These can seem like very hard or academic questions but they are of significance to investors and their expectations of investment outcomes.

Stochastic modelling can provide a simple solution to these questions in a direct and powerful way.

It provides a method to link the risk profiles directly to a chosen definition of risk.

Frequently, portfolios are designed by reference to annual return volatility for the different ATR levels. However, from an investor’s point of view this is not very meaningful.

A more useful measure might be the potential range of outcomes in, say, retirement income or the potential size of a shortfall and likelihood of its occurrence.

For example, if an investor’s target is to have £200,000 in 15 years time, it might be useful for the investor to know that he or she has a 70 per cent chance of achieving this but a 30 per cent chance of failing to do so, with a likely shortfall of £30,000. The investor is then in a much better position to understand the risk being run.

Why quality mattersIn addition to providing a clear linkage between a client’s ATR level and the portfolio recommended, stochastic modelling has a major additional benefit.

It can be used to produce an “efficient frontier” of asset allocations to deliver the best return for each ATR profile. This ability to diversify the portfolio scientifically is potentially an enormous benefit to clients but this benefit is very dependent on the quality of the stochastic asset model used.

What is a good or quality stochastic model?

Briefly, a good stochastic model simulates the long-term behaviour of investment markets. From an understanding of the structure of market movements, it is possible to forecast how different types of assets will move relative to one another. This enables investors to build portfolios or asset allocations which maximise the long term return for a given level of risk, that is, to optimise the benefits of diversification and therefore lie on the “efficient frontier”.

The focus of a good stochastic asset model on the long term means that investment decisions are not unduly influenced by shortterm market conditions such as the current sub-prime credit crunch.

Value-added service opportunityAlas, efficiency, like weight, must be maintained over time and through consistent monitoring and adjustments. To maximise the benefit to clients, portfolio efficiency can be maintained by:

l regularly reviewing the relative risk/ reward attractiveness of different asset classes;

l identifying the most efficient asset mix; andl undertaking regular rebalancing to bring a client’s portfolio back to the efficient frontierasset allocation.

This process can be demonstrated to deliver a significantly higher expected return to investors in the long term. It also avoids risk profile drift. This drift occurs when investors fail to review and rebalance portfolios and results in a mismatch of the portfolio to the investor’s risk profile.

The benefits of using a high-quality stochastic asset model are considerable. Not only does it provide a robust and transparent linkage between risk profiling and a well understood definition of risk, t also enables clients to build efficient portfolios that maximise the return for the accepted level of risk.

Additionally, the ability to communicate the risk and reward trade-off to investors allows advisers to convey realistic expectations of outcomes.

Advisers have at their fingertips a powerful way of delivering enormous added value to clients and meeting the FSA’s treating customers fairly requirements.

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