Stock Market

The current approach to financial advice is to put the client into a category, based on an assessment of their “risk profile”. Each category has assigned to it an investment strategy according to level of “risk”; for example a “conservative” category may have 80% of investments in deposits and bonds and 20% in shares and property, because deposits and bonds are considered less “risky” than property and shares. The investment strategy recommended by the financial adviser is determined by the category to which the client is assigned.

In this context, risk usually means the level of variability in investment returns over one year. For example, on average shares might be expected to return 8% over 2016/2017, but there is also a reasonable chance they will return as low as -5% or as high as 20%. Deposits and bonds, on the other hand, might be expected to return 2.5% over 2016/17, but it is unlikely they will return less than 1.5% or more than 3.5% over that period. This variability is referred to as “risk”. Generally, the higher the variability (‘risk”), the higher the expected return. So whilst the return on shares is more variable than the return on deposits, over the long –term shares should outperform deposits.

A person’s “risk profile” is a measure of how uncomfortable they are with variability. Someone who stays awake at night worrying that their investments might fall in value may be considered “conservative” or “defensive” i.e. they have a low risk tolerance – they would rather accept a lower investment return and experience less variability. Such a person would be more comfortable invested in deposits and bonds than in property and shares.

This approach is used because it is simple (albeit time-consuming) – the result can be delivered to a client after completion of a questionnaire in a meeting with a financial adviser. It is also used because, until now, there has not been a tool available that properly shows people the impact of different investment strategies on a person’s financial goals (rather than just the variability in annual returns).

The problem with this approach is that it may produce outcomes that are nowhere near as good as they could be – for example a retirement income of $60,000 per year rather than a possible $80,000 per year. For some people this can amount to hundreds of thousands of dollars worse off in retirement than need be.

The two key issues with this approach are:

  • It is focussed only on short term (typically annual) variability in investment returns rather than the likelihood of achieving financial goals, such as an adequate retirement income.
  • It does not take into account each person’s unique set of circumstances such as age, current assets, expected savings and expenditure; nor their financial goals such as funding a world trip, paying kids education fees, undertaking a major renovation, retirement income or legacy.

The following simple example shows the shortcomings of using the current risk profiling approach to determine investment strategy. Note that the example is simple and the two scenarios included are very different, so as to highlight the key principle. However, the principle applies to all situations, including the important question of investment for retirement.

Example:

Suppose Peter and Jane are both assessed to have a “moderate” risk profile i.e. they are prepared to take a little variability in returns in order to achieve a better outcome. And suppose the following:

Peter

  • $50,000 to invest
  • wants to use this investment in 2 years time to pay for a once-in-a-lifetime world trip that will cost at least $50,000 but the more money he has, the better his trip

Jane

  • $50,000 to invest
  • wants to use this investment to cover uni fees for her two kids, starting in 15 years time – she estimates this will amount to $120,000.

If the investment strategy for both Peter and Jane is the same because they are both assessed as having a “moderate” risk profile then their outcomes might look something like this:

Peter: Value of Investments in 2 years time, “Moderate” Investment Strategy (net of tax)

Likelihood 95% 75% 50% 25% 5%
Value Investments At Least  

$50,000

 

$53,000

 

$55,000

 

$57,000

 

$60,000

For Peter this investment strategy seems reasonable – there is a very high chance, 95%, that he will have at least the $50,000 that he needs for his trip and a fair chance, 50% or 1 in 2, that he will have at least $55,000 – an extra $5,000 – which will enable him to visit another country. Whilst a higher share allocation might increase the chance of Peter achieving $60,000 or more, it will also increase the chance of falling below the $50,000 minimum he needs. So for Peter, this strategy works well.

Jane: Value of Investments in 15 years time, “Moderate” Investment Strategy (net of tax)

Likelihood 95% 75% 50% 25% 5%
Value Investments At Least  

$75,000

 

$84,000

 

$92,000

 

$102,000

 

$120,000

For Jane, this investment strategy does not provide a good chance of achieving the outcomes she is after. Indeed there is only a 5% chance that she will be able to cover the uni fees for her kids. Could another investment strategy provide a better chance of Jane achieving her goals? Well, yes. A higher share allocation will actually increase the chance that Jane will reach her target, despite the fact that share returns are more variable in the short term. Why is this so? Because the daily, weekly, monthly and even yearly ups and downs of the share market even out over time and are outweighed in the long-term by the tendency for the total return from shares (price increases and dividends combined) to substantially exceed the return from deposits and bonds. Below are the results for Jane if she follows an “Aggressive” investment strategy (mostly shares and property, only a little in deposits and bonds).

Jane: Value of Investments in 15 years time, “Aggressive” Investment Strategy (net of tax)

Likelihood 95% 75% 50% 25% 5%
Value Investments At Least  

$87,000

 

$105,000

 

$128,000

 

$160,000

 

$217,000

So, for Jane it is actually less risky, in the proper meaning of the word, to be invested more in shares (Aggressive Investment Strategy) than deposits and bonds (Moderate Investment Strategy). That is, she has a much lower chance of failing to meet her goals if she invests more in shares. She just needs to learn to ignore the short term-ups and downs in the share market that she will experience on the way through.

The key principle here is that “risk” is the chance of failing to meet goals. In the case of investing, risk is the chance that investments will not deliver financial goals e.g. a retirement income of $60,000 per year from retirement age to at least age 90. And that will depend not only on investment strategy but also on current financial position and the timing and size of financial goals.

Of course, some people cannot help being anxious about the ups and downs of property prices and share markets. However, the same principle still applies – the best investment strategy is the one that produces the lowest chance of failing to meet financial goals – but the range of suitable investment strategies may be limited so as to exclude those that are too variable and will cause too much anxiety, even if that means a lower financial outcome. For such people, understanding this trade-off between short-term variability in returns and financial outcomes is essential in making decisions on investment strategy.

So, to help a client choose the best investment strategy, an adviser needs to:

  • Know the client’s current financial position
  • Know the client’s financial goals
  • Understand the client’s true risk profile i.e. what is an acceptable chance of failing to meet their financial goals
  • Show the client the trade-off between short-term (e.g. annual) variability in returns and their financial goals so they can make an informed decision about how much short-term variability they can tolerate in order to achieve an acceptable financial outcome
  • Optimise the investment strategy so as to maximise the client’s financial outcomes subject to an acceptable risk of falling short and an acceptable level of short-term variability

To do all of these requires considerable financial modelling capabilities combined with ultra high-speed computer processing. The good news is that Investfit is now available to advisers.

To learn more about how Investfit can help you, click here