Prior to investing on behalf of a client, it’s critical to gain a thorough understanding of the client’s risk tolerance. Asset Allocation construction is based on risk and return objectives.
Defining one’s risk tolerance is historically accomplished through questionnaires or through a conversation. It’s always been a challenge to pinpoint somebody’s risk tolerance, and what that means to him or her. For example, somebody may say on a scale of 1-10 he’s a “7”. What does that mean to that person? Just as importantly, what does a risk score of “7” mean to the Financial Advisor? It may mean he doesn’t want to invest in speculative stocks, but only blue chips (e.g. Johnson and Johnson, Walmart). Or perhaps it means he wants a portfolio of 70% stocks, and 30% bonds? How should the Financial Advisor interpret a score of “7”?
Riskalyze provides a solution. After answering approximately half a dozen questions Riskalzye will provide a score on a scale of 1-100 (1 is the most conservative, and 100 most aggressive). Riskalyze also quantifies the portfolio on scale of 1-100. It’s critical the portfolio approximately matches the risk tolerance of the client. Riskalyze displays portfolio risk by showing a 95% likelihood of the range of returns over a six month time horizon.
Displaying this range of returns in not only percentages, but also dollars is powerful. For example: If a client has a $2,000,000 portfolio, perhaps they feel they’re comfortable with a temporary decline of 20%. However, will they lose sleep with a temporary decline of $400,000? Twenty percent is $400,000 but displaying in dollars instead of percentages has a more significant impact. If a $400,000 decline is too much to stomach, I can manually lower the risk score by changing the composition of your portfolio. This will likely narrow future range of returns.
Riskalyze also offers the ability to stress test the portfolio against different scenarios. For example, wouldn’t you like to know how your portfolio would have performed in bad times (e.g. Financial Crisis)? Wouldn’t you also want to know how it would perform in good years (e.g. 2013)? Viewing performance in bull and bear markets is another way to distinguish if the range of returns is appropriate.
What if your investment didn’t exist in 2009? Not to worry, based on risk and return analytics Riskalyze estimates how the investment would have performed had it been in existence through a method called extrapolation. This means Riskalyze utilizes advanced analytics to find a similar security with a longer track record. Riskalyze then uses the security with a longer track record to score that particular asset (1-100) and display accurate historical performance.
The goal is to not capitulate. One of the worst things an investor can do during a downturn is sell after a significant decline. Riskalyze is a tool that can help avoid this predicament. By analyzing the likely range of returns over the next 6 months (in dollars), I can help ensure the portfolio matches your risk tolerance. This equates to a higher probability of staying on track, and not panicking during volatility.
I look forward to introducing Riskalyze to clients during quarterly conference calls, and semiannual meetings. If you want to discover your personal score visit my website (www.snyderassetmgmt.com) and click “What’s Your Risk Number?” in the center of the page.
Philip B. Snyder, CFA