Everyone wants Returns – but at what Risk?

Why modern portfolio management systems that can assess the risks associated with the return assumptions used when projecting future wealth and income are an essential FinTech tool in today’s wealth management industry.

Why Focus on Risk?

When the markets are running and consumer costs are low, no one seems to care about risk — every investment choice seems to work out and it seems to just be a matter of ‘how positive are the returns?’. However, when the stock markets are down double digits and inflation is skyrocketing, risk suddenly comes into focus. So, in today’s market, the question becomes ‘how much risk do I have to take in order to achieve the returns that I need?’ and ‘do I have the tolerance and risk capacity to withstand prolonged market downturns?’.

Risk is a Choice and an Opportunity

Risk comes from the early Italian word Risicare, ‘to dare’, described as the act of undertaking an adventure with two distinctly extreme outcomes: death or untold riches.

Risk is certainly inherent where money is concerned as well — and it is impossible to avoid it completely even if you wanted to. For example, if you do not invest at all(like stuffing cash in a mattress),8% inflation eats away at the value of that cash – which is risk. When investors forgo the immediate gratification of spending the money they have on hand, it is because they expect to get more satisfaction from it later. That goal requires taking risk, because only risk is compensated through returns. Therefore, risk is a choice that clients make dependent on several factors. Risk decisions are interwoven throughout the wealth management process and, as an advisor, you need to help your clients make these choices in striving to attain their wealth accumulation goals. You need to ensure clients are taking on the appropriate amount of risk. Advisors that can demonstrate their ability to assess these risks through the use of advanced analytics will provide differentiating advice that sets them apart in the world of client experience.

It’s all About Risk… But Risk is Not a Number….

So, the focus should be on risk, but risk is not a single formula that gives you a definitive numerical answer. In fact, there are multiple areas within wealth management where risk factors appear. These include:

  • The entire view of a family’s multi-generational wealth. This involves multiple portfolios with overlapping goals — not just a single investment portfolio.
  • A client’s (family’s) risk capacity/tolerance/appetite.
  • Taxes
  • Multiple goals and timelines over long horizons (5, 10, 30, 50 years).
  • Managing multiple clients efficiently so that you can scale and grow your business.

Multiple metrics are needed to characterize an “Investor’s Risk”

  • Risk capacity: how much risk you can handle financially.
  • Risk tolerance: a measure of how much risk you can withstand emotionally.
  • Risk Appetite: the willingness of investors to bear financial risk with the expectation of generating a potential profit.
  • Financial knowledge and sophistication of the client.
  • Information appetite. That is, how much information, in what format and how often, does the client require?

Identifying The Need to Take Risks for Long-Term Goals

Following the 2008 financial crisis, behavioural economics left academic circles and reached the mainstream with best selling books like Nudge, Thinking Fast and Slow and Predictably Irrational. Greater awareness of the irrationality of investors has created a demand for more sophisticated psychological assessment tools. These tools, however, attempt to assess the investor’s relationship to risk outside of the context of their financial situation and their financial goals.

“Risk tolerance” is one of these tools that has been assessed and regulated by investment firms for a very long time. These assessment tools have become a bit of a crutch for the industry, where advisors and compliance officers turn their focus towards not upsetting the client in the short term, at the expense of achieving longer-term objectives. This is because advisors have not had the tools in the past to demonstrate the risk levels required to achieve long-term goals.

Why Goals-Based Portfolio Management and Risk Analytics Are Essential

The availability of modern portfolio management systems that embrace goals-based portfolio management and risk analytics are now making it possible to close the loop and move away from overly simplistic portfolio risk scoring. It’s about moving beyond simplistic approaches in both assessing risk requirement of the client as well as the riskiness of the portfolio. They also make it possible to set realistic expectations with clients regarding the progression of the portfolio. As time goes by and factors change, either from the client’s perspective or through market movements, dynamic adjustments to the plan can be made with the long-term objectives in focus.

This is particularly important when multiple goals need to be considered. Sophisticated systems can help the client to see forecasted probabilities of success across multiple goals that can then be prioritized and adjusted based upon changing circumstances.

By moving the conversation away from short-term portfolio risk and reframing it in terms of achieving long-term goals, the advisors will help the investor to keep their eye on the purpose for their investing and help them avoid the traps of their own financial biases.

 

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