expected returns for all of the assets in any given portfolio it is possible to calculate the optimal portfolio mix for any degree of risk. Each portfolio on this “efficient frontier” will generate the highest possible rate of return for any specific level of risk, with risk being measured by the standard deviation of returns. Any other portfolio which exhibits the same standard deviation (risk) will generate lower returns and will therefore be considered inefficient.
Another way of saying this is, the investor must increase the expected return by the maximum amount for each additional unit of risk he is willing to take. The increase in return vis-à-vis any increase in risk is measured by several functions including the Sharpe Ratio, Treynor Ratio, Sterling Ratio and others.
The number of assets in the portfolio is less important than the relationship of those assets.
For example, if a portfolio consisted of only two assets with a perfectly negative correlation and differing volatilities (standard deviations), there is some mix of those two assets that will provide 0% portfolio risk and a predictable rate of return. Therefore having many assets in a portfolio will not reduce the systematic risk in the portfolio as much as having negatively correlated assets. It is a misconception, albeit a widely held one, that investors must accept higher levels of risk to achieve higher returns.A Clear, Practical and Repeatable Methodology
Developing successful investment strategies and competing for investment capital depends on the advisors ability to demonstrate to prospective clients that they have a clear and rational method, such as the method that follows, for developing and implementing investment plans.
1. Establishing the Risk Profile
How much risk can your client comfortably accept with any investment portfolio?
The classic answer from investors to this question is “I want a 25% return and zero risk”. Not much you can do with that, but at least they are aware that investments are inherently risky. A review of the current portfolio’s risk characteristics with the client should give you and the investor a good idea of how much risk he is willing to take. Do not be generic in specifying this risk (i.e.: growth & income or aggressive). Risk is a function of how much loss of principal (real or nominal) the client is willing to accept in any 12-month period. In general and assuming a balanced portfolio, risk levels should never exceed -12.50% (minimum ROR) in any 12-month period.
One of our clients had a fairly reasonable way of determining a client’s risk tolerance. He asked the client “if, due to market circumstances, your portfolio is down over 15% in the next 12 months, would you still hire me as your financial advisor”? If the answer is “no”, then how about 10%, and so on. This line of thought forces the client to seriously consider what, if any, loss he might be comfortable with.
It is imperative that you have a quantitative answer to this risk profile since it is intrinsically tied to any solution you will develop to achieve investment objectives.
For example, you might establish a set of reasonable investment objectives and the range of risk associated with each as follows.
From a marketing stand point, there are very few investors who would not pay to know how much risk they are currently taking with their portfolio and what kind of performance might be expected. Managing the investor’s risk and expected performance are critical in providing sound financial advice.
In the late 1980’s a large mutual fund company sent out a simple mailer to approximately 1 million prospects. All it said was “would you like to know how much risk you are taking with your current investments”. They received over 300,000 responses. Clearly, the investor’s attitude towards risk is paramount in designing any portfolio strategy.
Some years ago I was working with an $86 million pension fund in Chicago that wanted to know what level of risk and return they might expect from their current mix of investments. The analysis demonstrated that, within the 90% probability range, they had a risk of losing 9.6% of their principal in any 12 month period. Clearly, this was much greater risk than they were comfortable with from an actuarial and funding perspective. Understanding this, we were able to then design a portfolio that was more compatible with their risk profile.
2. Financial Objectives (Goal Setting)
What should investors achieve with an investment portfolio?
In general, the primary objective for any investment portfolio is to provide sufficient capital and income for the investor to live “comfortably” in post-retirement years. For larger estates, the objective may be substantially different, but in all cases you must be able to evaluate alternative scenarios and their likely outcomes.
While it is not necessary to have a detailed estate plan in place for most investors, nonetheless it is important that some objectives are clearly set out and that the probability of achieving those goals is evaluated by your portfolio analytical tools. AdvisoryWorld’s SCANalytics tool allows advisors to clearly establish financial objectives and quickly determine of the current or proposed portfolios are likely to achieve those objectives.
- What financial goals does the investor want to achieve? Retirement, college, major purchases, weddings, etc.
- When does the investor hope to reach them? How many years until the capital is needed and how many years to use the capital (mortality tables)?
- How much risk is the investor willing to accept to achieve those goals? Some goals may require more or less risk than others.
- How much money can he invest now and in the future? What capital is available now and what might be available in the future (part of the cash flow analysis)
- How much money will be needed to achieve the goals based on expected return? How much money will be needed, for how long and what is the source of funds (i.e. which investment basket is used to fund the goal)?
3. Analyzing Current Investments
It takes some time and thought to review your client’s finances and financial goals, but the time and effort are well worth the results. Most individual investors acquire assets without much, if any, consideration given to their financial objectives, expected portfolio rates of return, risk, and the inter-relationship or balance of the assets involved. They generally end up with a mix of unrelated investments which, as a whole, can never fulfill the investor’s policies and objectives. Advisors need to design portfolios that will achieve financial objectives by matching assets according to risk/return trade-offs. If capital is allocated efficiently, portfolio returns will generally be higher over the long-term, and portfolio volatility will be lower. Establishing well thought out objectives can result in portfolios with greater predictability and stability of returns and theoretically optimal performance.Review and analysis of risk and performance characteristics of existing investments
It is virtually impossible to know how to achieve your objectives unless you know where you’re starting from. Once you know what the investor’s risk profile is, you will need to understanding how much risk is exhibited by the investor’s current investment mix, the expected rate of return and whether or not this level of risk exceeds the investor’s tolerance for downside risk.
The process begins by using a sophisticated analytical tool such as SCANalytics to determine the portfolio’s historical mean or annualized return, the standard deviation (a measure of volatility), the correlation matrix for all assets (securities) that comprise the portfolio and the probability range of returns (upper and lower boundaries).