Time for a pragmatic approach to risk profiling

Ever since the end of the ‘bear’ market in the Spring of 2003 I have been struck by the energy and intellect which has been directed at the issue of establishing each client’s attitude to risk.  Such paranoia has been evident after all previous major stockmarket corrections: after 1974, 1987 and now since 2003.

 Frankly nothing has changed in the last 100 years let alone the last 30 or so since we were all encouraged to bath together to save energy!  The message should be clear to us all: in the short term cash is king but in the long term equities unquestionably are king.  This truism is fundamental to the whole premise for free market economics.

This leads me to another fact which has been obvious to actuaries and scientists since economics was invented.  This is that volatility on any long term chart always looks as if it has been greater in recent times than in previous periods.  This is an optical illusion used by sceptical would-be investors to ‘prove’ that it is no longer worth investing in equities!  In fact the nature of an exponential curve (the natural profile of a long term equity index) is that apparent volatility only looks to be less the further back you go.  This is amply demonstrated by looking back at Black Monday and the 1987 ‘crash’ which it heralded.  This was a significant bear phase (as can be seen on the chart) which has subsequently faded into the context of what it really was . . a blip or straightforward market correction.  Suddenly, with markets touching previous highs, the recent ‘crash’ also begins to look like a natural and unexceptional market correction.

 The chart clearly shows the difference between market price and likely intrinsic value.  Whilst market price is largely determined by the balance (or imbalance) of willing buyers and sellers it is clear that it fluctuates around real value.  There is no way that the value of a company like Tesco fluctuates with its share price.  Its value generally moves rather more gently to reflect the long term trends of its fundamental balance sheet, profit and other financial ratios.  What the chart actually highlights is the importance of time rather than timing.  Whilst timing may be important in the specifics of buying and selling – far better to buy when prices are below value and to sell when they are above value – it is time, holding a high quality, actively managed portfolio for the longer term, which delivers sound sustainable returns.

 This, the fourth dimension of time, should be the starting point for discussions about risk.  I believe that one can establish a neutral and totally practical approach to risk from which one can then deviate for more cautious or more adventurous investors.  Developing a matrix from the premise of ‘short term cash is king, long term equities are king’ is straightforward and simply requires filling in the gaps between short and long term.  I consider short term to be up to 5 years whereas I believe long term means beyond, say, 12 years.  If 0-5 years means all cash and therefore nil equities and 12+ years means 100% equities then we can simply interpolate between these points.  I would say 5-8 years means 20-30% equities whilst 8-12 years means 50-60% equities.  Clearly it is also very important where the non-equity balance is invested but assuming this is also risk-graded in some sensible way we have a good working model for most average investors.

 Any investor investing for the future should attempt to predict the investment time horizon for different portions of his/her capital and then invest accordingly – in a different style of portfolio or fund for each time period.  The idea of determining each client’s ‘risk profile’ and then matching asset classes to this preference completely misses the point.

 As I see it the average investor would benefit from being in cash for any short term requirement and in a well-spread, actively-managed equity portfolio for long term requirements.  It is certainly not low risk for investors to be stuck in cash for the longer term.  Such an approach would be irresponsible – as the court has ruled in some well-known trust cases.

This brings me on to the contemporary approach of asking clients to complete long and tortuous risk questionnaires at the end of which, in true ‘Little Britain’ style, “computer says you are a cautious investor!”  Clients do not understand this process nor do they have sympathy with the conclusions.  If advisers follow this route to protect themselves, from a compliance perspective, I rather doubt its long term effectiveness.  Clients need to thoroughly understand how the conclusion about their risk tolerance was ascertained otherwise it might be considered false.  Frankly, a simple enquiry as to whether they believe they are cautious, neutral or adventurous investors would likely have been more effective. 

 I abhor such questionnaires.  Instead of subjecting clients to this torture I recommend a meaningful discussion about the nature of equity investment, its inherent volatility and the part played by time.  Such open and practical discussions should be properly documented.  The client should then be encouraged to analyse his/her future capital needs into time horizons.  These will then indicate a neutral position from which one can vary to reflect how adventurous, or otherwise, they are.

The era of the 1-10 risk categorisation of both clients and asset classes is long gone, thank goodness.  Matching a category 3 client with a long term Gilt approach never did make much sense.  In my view, however, we are going overboard with the academic approach and yet have still finished up categorising clients too broadly rather than looking at the main factor in risk – time.  So I give you my complete thoughts on basic risk profiling in the table.  Neutral means investing in the most obvious portfolio styles to reflect time horizons.  Only then should one consider the impact of the non-neutral client!

Paul Wilcox,
Chairman & Technical Director, WAY Group.

Posted on 24th October, 2006 |
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