ManagingManagingRisk ToleranceRisk Tolerance

Geoff DaveyGeoff DaveyCo-Founder and CEOCo-Founder and CEO

FinaMetrica Pty LimitedFinaMetrica Pty Limited

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The Meaning ofThe Meaning of“Risk Profile/Profiling”“Risk Profile/Profiling”

An assessment of an An assessment of an individual’s risk tolerance.individual’s risk tolerance.

oror

An assessment of the An assessment of the risk(/return) in an investment risk(/return) in an investment strategy (thought to meet the strategy (thought to meet the clients needs.)clients needs.)

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Managing Risk ToleranceManaging Risk Tolerance

Assess your client’s Assess your client’s financial risk tolerance.financial risk tolerance.

Apply that assessment Apply that assessment when formulating advice.when formulating advice.

Obtain your client’s Obtain your client’s properly informed properly informed commitment.commitment.

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WhatWhatisis

riskrisktolerance?tolerance?

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Risk ToleranceRisk ToleranceHow much risk I How much risk I choosechoose to take. to take.(a psychological construct)(a psychological construct)

Risk CapacityRisk CapacityHow much risk I can How much risk I can affordafford to take. to take.(a financial construct)(a financial construct)

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Uh?

What’s yourrisk tolerance?

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Assessment TechniquesAssessment Techniques

Interview-basedInterview-based(subjective clinical judgements)(subjective clinical judgements)

versusversus

Test-basedTest-based(psychometric instrument)(psychometric instrument)

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PsychometricsPsychometrics

Psychology and statisticsPsychology and statistics

Science of test constructionScience of test construction

Standards for evaluating testsStandards for evaluating tests

Validity, reliability and accuracyValidity, reliability and accuracy

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Test DevelopmentTest Development

Pool of Questions

Sample Questionnaire

Useability Trials•Understand?

•Answer?

Norming Trials

Statistical Analysis•Validity?

•Reliability?•Accuracy?

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PsychometricPsychometricRisk Tolerance TestRisk Tolerance Test

20+20+Plain EnglishPlain English

QuestionsQuestions

ScoringScoringAlgorithmsAlgorithms

Risk ToleranceRisk ToleranceReportReport

““Norms”Norms”DatabaseDatabase

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Q3 When you think of the word 'risk' Q3 When you think of the word 'risk' in a financial context, which of the in a financial context, which of the following words comes to mind following words comes to mind first? first?

    Danger. Danger.

    Uncertainty. Uncertainty.

    Opportunity. Opportunity.

    Thrill. Thrill.

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Q14 Investments can go up or down in Q14 Investments can go up or down in value, and experts often say you should value, and experts often say you should be prepared to weather a downturn. By be prepared to weather a downturn. By how much could the total value of how much could the total value of all all your investmentsyour investments go down before you go down before you would begin to feel uncomfortable? would begin to feel uncomfortable?

Any fall would make me feel uncomfortable. Any fall would make me feel uncomfortable.

10%. 10%.

20%. 20%.

33%. 33%.

50%. 50%.

More than 50%. More than 50%.

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Risk Profile ReportRisk Profile Report

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““Know The Client”Know The Client”

ComplianceCompliance

MarketingMarketing

SalesSales

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Industry-Standard Industry-Standard QuestionnairesQuestionnaires

In theory,In theory,should not work.should not work.

In practice,In practice,do not work.do not work.

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Insights from Insights from Psychology and Psychology and Psychometrics on Psychometrics on Measuring Risk Measuring Risk ToleranceTolerance

Journal of Financial Journal of Financial Planning, April 2005Planning, April 2005

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Industry-Standard Industry-Standard QuestionnairesQuestionnaires

Too many “bad” Too many “bad” questions.questions.

Too few “good” Too few “good” questions.questions.

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ReliabilityReliability

Test Score = True Score Test Score = True Score ± Error± Error

Reliability (r) ~ Correlation between Reliability (r) ~ Correlation between Test Score and True ScoreTest Score and True Score

Error (SEError (SEmm) = StdDev x ) = StdDev x (1-r)(1-r)

Reliability (r) ~ f(no of questionsReliability (r) ~ f(no of questions22))

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Risk Tolerance CharacteristicsRisk Tolerance Characteristics

4 types: physical, ethical, social and financial4 types: physical, ethical, social and financial Normally distributedNormally distributed No sub-factorsNo sub-factors Males > females by 1 sdMales > females by 1 sd Negative correlation with age, marital status and Negative correlation with age, marital status and

dependantsdependants Positive correlation with income, assets and Positive correlation with income, assets and

educationeducation Advisers > clients by 1 sdAdvisers > clients by 1 sd Clients’ estimates: correlate .68Clients’ estimates: correlate .68 Advisers’ estimates: correlate .38Advisers’ estimates: correlate .38

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Standard MethodsStandard Methods

PPllaannnneerrss’’ EEssttiimmaatteess

77 00

66 44 22 00

55 33 44 2266 1166 44

44 66 2244 3355 1188 33

33 11 1133 1155 99 11

22 88 11 33 22

11 00

11 22 33 44 55 66 77 AAccttuuaall SSccoorreess

TToottaallss 00 1188 4422 8833 4477 88 00 119988

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Managing Risk ToleranceManaging Risk Tolerance

Assess your client’s Assess your client’s financial risk tolerance.financial risk tolerance.

Apply that assessment Apply that assessment when formulating advice.when formulating advice.

Obtain your client’s Obtain your client’s properly informed properly informed commitment.commitment.

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Gap AnalysisGap Analysis

The “gap” between …The “gap” between …

risk requiredrisk required (the risk inherent in (the risk inherent in the return required to achieve goals)the return required to achieve goals)

andand

risk tolerancerisk tolerance (the preferred (the preferred risk/return trade-off)risk/return trade-off)

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Gap AnalysisGap Analysis

Bill and Suzie need an Bill and Suzie need an aggressive portfolio to achieve aggressive portfolio to achieve their goals, but …their goals, but …

Bill’s risk tolerance indicates he Bill’s risk tolerance indicates he would normally choose a would normally choose a conservative portfolio and conservative portfolio and Suzie’s suggests a balanced Suzie’s suggests a balanced portfolio.portfolio.

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Linking Spreadsheet*Linking Spreadsheet*

Risk ToleranceRisk Tolerance Risk RequiredRisk Required

* Methodology for comparing portfolio * Methodology for comparing portfolio risk to risk tolerancerisk to risk tolerance

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Expressing Scores asExpressing Scores as% Growth Assets% Growth Assets

Growth% by Score (n=20,709)

y = -1.6662E-6x3 + 2.6204E-4x2 + 2.6792E-4x

R2 = 9.9508E-1

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 10 20 30 40 50 60 70 80 90 100

Score

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Comfort ZonesComfort Zones% Growth Assets

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 10 20 30 40 50 60 70 80 90 100

Risk Tolerance Score

<=Exact Match Plus 0-10% Plus 10-20% Plus >20%

'Comfort' Zone

'Discomfort' Zone

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Resolving the “Gap”Resolving the “Gap”

Take more risk,Take more risk,

and/or and/or

Lower goalsLower goals

and/or and/or

Invest moreInvest more

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The Planning ProcessThe Planning Process Assess risk tolerance.Assess risk tolerance.

Determine risk (return) required.Determine risk (return) required.

Gap analysis andGap analysis and resolution. resolution.

Explain risk. Explain risk.

Obtain properly informed Obtain properly informed commitment.commitment.

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Explaining RiskExplaining Risk

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Explaining Downside Risk: Explaining Downside Risk: 2020thth Century Century

Your Financial Plan

Blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah Negative return 1 year in 5. blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah

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Explain the RisksExplain the Risks“Let me tell you about the weather “Let me tell you about the weather

around here …”around here …”

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Short-Term RiskShort-Term Risk

It does rain here!It does rain here!

Sample Portfolio: 50% Defensive, 50% GrowthSample Portfolio: 50% Defensive, 50% GrowthCash 10%, Bonds 25%, Int’l Bonds 15%,Cash 10%, Bonds 25%, Int’l Bonds 15%,

CAN Stocks 25%, US Stocks 15%, Int’l Stocks 10%CAN Stocks 25%, US Stocks 15%, Int’l Stocks 10%

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Portfolio StatusPortfolio Status(How often does it rain?)(How often does it rain?)

FallingRecovering

Rising

FallingRecovering

Rising

FallingFalling33%33%

RecoveringRecovering21%21%

RisingRising46%46%

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Falls AnalysisFalls Analysis(How heavy and for how long?)(How heavy and for how long?)

Total

1 36 362 5 53 3 1 4

4-6 6 67-12 1 1 2

13-24

>24 1 1

Total 51 2 1 54

< 10%

Depth of Fall

33% to

49%=>

50%

20% to

32%

Length of Fall

(Months)

10% to

19%

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Top Ten FallsTop Ten Falls“Big Wets”“Big Wets”

Depth of Fall

Started Falling

Months in Fall

Months to Recover

Completed Recovery

-20.3% Nov-73 11 8 May-75 -16.2% Sep-00 31 10 Jan-04 -13.3% Sep-87 3 13 Dec-88 -9.9% Apr-81 6 1 Oct-81 -8.1% Jan-90 4 8 Dec-90 -7.4% Jul-98 2 2 Oct-98 -6.8% Mar-80 1 1 Apr-80 -5.7% Jul-75 3 3 Dec-75 -5.6% Feb-94 5 7 Jan-95 -5.6% Dec-81 7 1 Jul-82

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Properly Informed CommitmentProperly Informed Commitment

Clients better understand and are more committed to Clients better understand and are more committed to your advice becauseyour advice because

risk tolerance was properlyrisk tolerance was properly assessed, assessed, “ “gaps” were identifiedgaps” were identified meaningfully, meaningfully, trade-off decisions weretrade-off decisions were made knowingly, and made knowingly, and the risks were explained in athe risks were explained in a manner that the client could manner that the client could understand. understand.

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