October 2018

Profile to Portfolio: Where is the missing link?

FinaMetrica Pty Limited - Sunday, 21 October 2018

There is a “leap” from a consumer “risk profile” to the actual portfolio. Although the default assumption is that an extremely high-risk tolerance might translate to 100% equities and extremely conservative might be all cash – why is this?
 
In a research paper by Shawn Brayman, Nicki Potts, Kira Brayman and Yegor Kommissarov presented at the Academy of Financial Services in Chicago in October they explored several methodologies that “map” from the client’s profile to portfolio.
 

• It compared three primary methodologies from the academic literature or regulators - Grable (2008), Davey (2015), MIFiD-II a European regulatory outline, against alternatives and each other;
• There was a strong correlation between Davey and MIFiD-II on mapping profiles to product based on the Value at Risk (VaR) of the products. Grable was similar but with a more linear scaling of the level of risk by profile;
• There were three methodologies used in mapping – behavioural expectation by consumers; exposure to equity holdings or VaR. Behaviourial expectation and exposure to equities is a valid heuristic but insufficient to scale to the wide variety of portfolios and products in the marketplace;
• Although the VaR calculation is recognized in multiple sources as the preferred methodology to align client concerns of drop in the value of their portfolio to the actual products, we found a fundamental flaw in the alignment of VaR (or volatility) and largest drops. It appears as if we misrepresent the likelihood of drops to clients. Clients actually live through events that are worse than what we describe as occurring once in 100 years as much or more than 9% of the time.

 
The purpose of the mapping is to align investments that will be suitable for the client, that they will understand the risk associated with, and if that risk should be realized the client will not take inappropriate actions (selling and crystalizing loses). A key challenge is how to explain the risks to clients in a manner they can understand?
 
This research found there seems to be a “loose consensus” on the mapping but there is a disconnect on the usage of volatility or standard deviation as the metric to explain this as it does not seem to relate to client understanding of “how far can it drop”. The methodology outlined by Davey (2015) of greatest declines or falls appears to have the strongest relationship to actual understanding and expectation by clients.

Risk Profiling Trade-offs

FinaMetrica Pty Limited - Sunday, 21 October 2018

Professional Judgement or Just My Opinion?

Advisors must reconcile conflicts between a client’s risk tolerance, risk capacity, risk need, composure, previous experience, time horizon and more in determining an investor profile and resulting personalized investment policy. There is little or no body of knowledge on how these trade-offs occur or what constitutes a “best practice” in applying “Professional Judgment” to ensure client best interest are met.
 
Research by Shawn Brayman presented at the Academy of Financial Services Conference in Chicago October 2018 explored if there was a consensus among advisors on what factors are material in deriving a risk profile. The results were ambiguous at best.

• Capacity, Time Horizon and Tolerance (behavioural) are consider the most important factors to consider, in that order. Composure, Experience and Need were considered less important;
• About 40% of advisors feel a client’s lack of prior equity experience is immaterial while 60% feel it should impact the portfolio construction and potentially limit equity exposure;
• Four of five advisors felt that if a client had “more capital than goals required” they would explore reducing risk while one in five felt goals “change” so it is better to continue to maximize returns regardless.
• One of the biggest disagreements was whether a client can take more risk than supported by their profile to achieve their goals? Fifty-three (53%) percent of advisors say no and 47% say yes.
• One in three advisors believe a client’s display of a lack of composure warrants a reduction in equity exposure and 2/3rds say no.
• There was a wide range of beliefs of the relevance of time horizon as a material factor running from 3 years to 15 years.

The conclusion of the research was that there was no current body of knowledge,  nor a consensus amongst advisors. The critical issue for planners is:

• Articulate your believes and policies and disclose these to clients for “properly informed consent”;
• Be consistent in application of Professional Judgement – do not make it up on a case-by-case basis.