For too long, the industry has been outsourcing asset allocation decisions to the risk score. This approach often results in portfolios that are disconnected from actual client goals and are unresponsive to changes in clients' financial situations. As a result, investors are not receiving truly personalized portfolios, leading to sub-optimal outcomes and the much bigger risk that clients don’t meet their goals.
Rather, our research advocates for an Investment Policy Process that appropriately balances the crucial elements of time horizon, risk tolerance, cash flows, and return objectives into a dynamic, ongoing strategy that adapts in real time to your clients' changing lives and market conditions.
Risk Scores Dominate Everything
According to none other than that bastion of financial education, the CFA Institute, an investment policy statement should be “a written document that clearly sets out a client’s return objectives and risk tolerance over the client’s relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirement and unique circumstances.” Simply put, the three pillars of the investment are the client’s required rate of return, risk tolerance, and time horizon.
Yet when it comes to financial planning and building a client’s portfolio, pretty much one component dominates everything—risk tolerance! Both the required rate of return and the time horizon are at best poor distant cousins in the discussion or at worst banished like Harry Potter to a closet under the stairs. And most often we see all the complexities of a client boiled down to a single number: the dreaded risk score. The score ends up being the virtually exclusive determinant of the client’s asset allocation, arguably one of the most important portfolio characteristics.
The Dangers Of An Over-Reliance On The Vagaries Of A Risk Score
On the surface, boiling a client’s risk tolerance down to a risk score may seem alluring. It’s easy to both understand and communicate. But it also fails to take into account any nuance into the client’s needs and circumstances. Using a risk score to build a client portfolio essentially nullifies an advisor’s great financial planning, throwing all that work out the window. The resulting portfolio is completely disconnected from the client’s financial plan.
There are numerous problems with this approach. First and foremost is that clients with vastly different circumstances can end up owning the same portfolio all because…wait for it…they have the same risk score. A 25-year-old should invest aggressively because of her circumstances, not because of her personality: there are 40 years until drawdowns really matter for consumption goals. A 75-year-old should invest more conservatively because of needs and circumstances: near-term losses cannot necessarily be recovered from the nest egg as it is being consumed.
Both of these clients can end up in a 60/40 portfolio if they have the same risk score. They have vastly different circumstances, but under the risk score approach, these differences are irrelevant. It’s the risk score that dominates the asset allocation. And to top it off, there have been a litany of behavioral finance research studies pointing out the flaws in the risk-scoring approach!
The Behavioral Backdrop
There are myriad well-documented behavioral issues related to risk tolerance questionnaires and risk scores. Where do we begin? Let’s start at a very basic level—the client. Risk scores fail to distinguish the degree of risk tolerance on a granular or individualized level (even if we accept the concept of volatility as risk) such that the vast majority of clients end up in the “moderate” risk tolerance bucket. The result is a one-size-fits-all solution – the polar opposite of the customization clients demands and advisors seek to provide.
As we have observed before, everyone starts out saying they are a long-term investor right up until the first patch of poor performance when they suddenly become obsessively interested in today’s/this week’s/this quarter’s returns. We have previously labelled this time inconsistency as poor emotional time travel.
Not only are the foundations of risk tolerance shaky to say the least, the near dictatorial power wielded by the risk tolerance questionnaire and risk score should be concerning from a behavioral perspective because it runs the risk of creating an anchor.
The Solution
It’s time to stop outsourcing asset allocation—the most important component of a client’s investment returns—to a risk score. The alternative is to connect the client’s financial plan (not the risk score) to a portfolio specifically customized for the client.
Achieving this goal of coherently connecting planning and investing requires a big idea. Instead of defining risk as volatility, the big idea is to define risk as “not having what you need, when you need it” and to then build portfolios seeking to minimize that risk. This is a significant leap forward for goals-based wealth management.
We believe that an “Investment Policy Process” (IPP) that better balances target return, time horizon, and risk tolerance will lead to improved client outcomes. We combine the IPP process and the Nebo Wealth platform using our pioneering portfolio optimization engine to construct the perfect-fit portfolio for every stage of life.
With the client’s specific time horizon, risk tolerance and Target Return set, with a click of a button, the Nebo Wealth platform enables you to build the perfect-fit portfolio for each client at every stage of life. This is all done in an open architecture platform allowing you to use your firm’s own Capital Market Assumptions, investment building blocks and preferred implementation (ETFs, individual stocks, or mutual funds). If the client’s goals and objectives change, the portfolio will seamlessly evolve as the client’s needs and circumstances change—you no longer rebalance to a static allocation. Instead, you re-optimize based on the dynamic nature of capital markets and client circumstances through a systematic, repeatable process to the new perfect-fit allocation.
A Leap Forward In Goals-Based Investment Management
Financial planning tools have done a great job of helping advisors build out the cash flows necessary to achieve a client’s long-term goals. However, these financial planning tools have also ventured into the world of asset allocation. And here, our view is that they fall woefully short. In a great number of cases, the client’s risk score ends up being the primary determinant of a client’s portfolio.
This article is an abstract of a recently published white paper, “The Perils of Outsourcing Asset Allocation to a Risk Score.” To read the full report, download here.
James Montier is a senior advisor for GMO, consulting on economic and market research; Martin Tarlie is the product lead for Nebo Wealth; and Matt Kadnar is the sales lead for Nebo Wealth.
The views expressed are the views of James Montier through the period ending June 2024 and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such.