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ManagingManagingRisk ToleranceRisk Tolerance
Geoff DaveyGeoff DaveyCo-Founder and CEOCo-Founder and CEO
FinaMetrica Pty LimitedFinaMetrica Pty Limited
© FinaMetrica Pty Limited 2006
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.)
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
WhatWhatisis
riskrisktolerance?tolerance?
© FinaMetrica Pty Limited 2006
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)
© FinaMetrica Pty Limited 2006
Uh?
What’s yourrisk tolerance?
© FinaMetrica Pty Limited 2006
Assessment TechniquesAssessment Techniques
Interview-basedInterview-based(subjective clinical judgements)(subjective clinical judgements)
versusversus
Test-basedTest-based(psychometric instrument)(psychometric instrument)
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
Test DevelopmentTest Development
Pool of Questions
Sample Questionnaire
Useability Trials•Understand?
•Answer?
Norming Trials
Statistical Analysis•Validity?
•Reliability?•Accuracy?
© FinaMetrica Pty Limited 2006
PsychometricPsychometricRisk Tolerance TestRisk Tolerance Test
20+20+Plain EnglishPlain English
QuestionsQuestions
ScoringScoringAlgorithmsAlgorithms
Risk ToleranceRisk ToleranceReportReport
““Norms”Norms”DatabaseDatabase
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
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%.
© FinaMetrica Pty Limited 2006
Risk Profile ReportRisk Profile Report
© FinaMetrica Pty Limited 2006
““Know The Client”Know The Client”
ComplianceCompliance
MarketingMarketing
SalesSales
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
Industry-Standard Industry-Standard QuestionnairesQuestionnaires
Too many “bad” Too many “bad” questions.questions.
Too few “good” Too few “good” questions.questions.
© FinaMetrica Pty Limited 2006
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))
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
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)
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
Explaining RiskExplaining Risk
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
Explain the RisksExplain the Risks“Let me tell you about the weather “Let me tell you about the weather
around here …”around here …”
© FinaMetrica Pty Limited 2006
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%
© FinaMetrica Pty Limited 2006
Portfolio StatusPortfolio Status(How often does it rain?)(How often does it rain?)
FallingRecovering
Rising
FallingRecovering
Rising
FallingFalling33%33%
RecoveringRecovering21%21%
RisingRising46%46%
© FinaMetrica Pty Limited 2006
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%
© FinaMetrica Pty Limited 2006
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
© FinaMetrica Pty Limited 2006
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.
© FinaMetrica Pty Limited 2006
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