Managing Risk Tolerance Geoff Davey Co-Founder and CEO FinaMetrica Pty Limited

© FinaMetrica Pty Limited 2006 The Meaning of “Risk Profile/Profiling” n An assessment of an individual’s risk tolerance. or n An assessment of the risk(/return) in an investment strategy (thought to meet the clients needs.)

© FinaMetrica Pty Limited 2006 Managing Risk Tolerance n Assess your client’s financial risk tolerance. n Apply that assessment when formulating advice. n Obtain your client’s properly informed commitment.

© FinaMetrica Pty Limited 2006 What is risk tolerance?

© FinaMetrica Pty Limited 2006 n Risk Tolerance How much risk I choose to take. (a psychological construct) n Risk Capacity How much risk I can afford to take. (a financial construct)

© FinaMetrica Pty Limited 2006 Uh? What’s your risk tolerance?

© FinaMetrica Pty Limited 2006 Assessment Techniques n Interview-based (subjective clinical judgements) versus n Test-based (psychometric instrument)

© FinaMetrica Pty Limited 2006 Psychometrics n Psychology and statistics n Science of test construction n Standards for evaluating tests n Validity, reliability and accuracy

© FinaMetrica Pty Limited 2006 Test Development Pool of Questions Sample Questionnaire Useability Trials Understand? Answer? Norming Trials Statistical Analysis Validity? Reliability? Accuracy?

© FinaMetrica Pty Limited 2006 Psychometric Risk Tolerance Test 20+ Plain English Questions Scoring Algorithms Risk Tolerance Report “Norms” Database

© FinaMetrica Pty Limited 2006 Q3 When you think of the word 'risk' in a financial context, which of the following words comes to mind first? Danger. Uncertainty. Opportunity. Thrill.

© FinaMetrica Pty Limited 2006 Q14 Investments can go up or down in value, and experts often say you should be prepared to weather a downturn. By how much could the total value of all your investments go down before you would begin to feel uncomfortable? Any fall would make me feel uncomfortable. 10%. 20%. 33%. 50%. More than 50%.

© FinaMetrica Pty Limited 2006 Risk Profile Report

© FinaMetrica Pty Limited 2006 “Know The Client” n Compliance n Marketing n Sales

© FinaMetrica Pty Limited 2006 Industry-Standard Questionnaires n In theory, should not work. n In practice, do not work.

© FinaMetrica Pty Limited 2006 Insights from Psychology and Psychometrics on Measuring Risk Tolerance Journal of Financial Planning, April 2005

© FinaMetrica Pty Limited 2006 Industry-Standard Questionnaires n Too many “bad” questions. n Too few “good” questions.

© FinaMetrica Pty Limited 2006 Reliability n Test Score = True Score ± Error n Reliability (r) ~ Correlation between Test Score and True Score n Error (SE m ) = StdDev x  (1-r) n Reliability (r) ~ f(no of questions 2 )

© FinaMetrica Pty Limited 2006 Risk Tolerance Characteristics n 4 types: physical, ethical, social and financial n Normally distributed n No sub-factors n Males > females by 1 sd n Negative correlation with age, marital status and dependants n Positive correlation with income, assets and education n Advisers > clients by 1 sd n Clients’ estimates: correlate.68 n Advisers’ estimates: correlate.38

© FinaMetrica Pty Limited 2006 Standard Methods

© FinaMetrica Pty Limited 2006 Managing Risk Tolerance n Assess your client’s financial risk tolerance. n Apply that assessment when formulating advice. n Obtain your client’s properly informed commitment.

© FinaMetrica Pty Limited 2006 Gap Analysis The “gap” between … n risk required (the risk inherent in the return required to achieve goals) and n risk tolerance (the preferred risk/return trade-off)

© FinaMetrica Pty Limited 2006 Gap Analysis n Bill and Suzie need an aggressive portfolio to achieve their goals, but … n Bill’s risk tolerance indicates he would normally choose a conservative portfolio and Suzie’s suggests a balanced portfolio.

© FinaMetrica Pty Limited 2006 Linking Spreadsheet* Risk Tolerance Risk Required * Methodology for comparing portfolio risk to risk tolerance

© FinaMetrica Pty Limited 2006 Expressing Scores as % Growth Assets

© FinaMetrica Pty Limited 2006 Comfort Zones

© FinaMetrica Pty Limited 2006 Resolving the “Gap” n Take more risk, and/or n Lower goals and/or n Invest more

© FinaMetrica Pty Limited 2006 The Planning Process n Assess risk tolerance. n Determine risk (return) required. n Gap analysis and resolution. n Explain risk. n Obtain properly informed commitment.

© FinaMetrica Pty Limited 2006 Explaining Risk

© FinaMetrica Pty Limited 2006 Explaining Downside Risk: 20 th 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 Risks “Let me tell you about the weather around here …”

© FinaMetrica Pty Limited 2006 Short-Term Risk It does rain here! Sample Portfolio: 50% Defensive, 50% Growth Cash 10%, Bonds 25%, Int’l Bonds 15%, CAN Stocks 25%, US Stocks 15%, Int’l Stocks 10%

© FinaMetrica Pty Limited 2006 Portfolio Status (How often does it rain?) Falling 33% Recovering 21% Rising 46%

© FinaMetrica Pty Limited 2006 Falls Analysis (How heavy and for how long?) Total >2411 Total < 10% Depth of Fall 33% to 49% => 50% 20% to 32% Length of Fall (Months) 10% to 19%

© FinaMetrica Pty Limited 2006 Top Ten Falls “Big Wets”

© FinaMetrica Pty Limited 2006 Properly Informed Commitment Clients better understand and are more committed to your advice because Clients better understand and are more committed to your advice because n risk tolerance was properly assessed, n “gaps” were identified meaningfully, n trade-off decisions were made knowingly, and n the risks were explained in a manner that the client could understand.

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