Managing Risk Tolerance

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ManagingRisk Tolerance

• Geoff DaveyCo-Founder and CEOFinaMetrica Pty
  Limited

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The Meaning ofRisk Profile/Profiling

• An assessment of an individuals risk tolerance.
• or
• An assessment of the risk(/return) in an
  investment strategy (thought to meet the clients
  needs.)

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Managing Risk Tolerance

• Assess your clients financial risk tolerance.
• Apply that assessment when formulating advice.
• Obtain your clients properly informed commitment.

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Whatisrisktolerance?
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• Risk ToleranceHow much risk I choose to take.(a
  psychological construct)
• Risk CapacityHow much risk I can afford to
  take.(a financial construct)

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Whats yourrisk tolerance?
Uh?
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Assessment Techniques

• Interview-based(subjective clinical judgements)
• versus
• Test-based(psychometric instrument)

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Psychometrics

• Psychology and statistics
• Science of test construction
• Standards for evaluating tests
• Validity, reliability and accuracy

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Test Development
Pool of Questions
Sample Questionnaire

• Useability Trials
• Understand?
• Answer?

Norming Trials

• Statistical Analysis
• Validity?
• Reliability?
• Accuracy?

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PsychometricRisk Tolerance Test
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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.
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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.
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Risk Profile Report
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Know The Client

• Compliance
• Marketing
• Sales

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Industry-Standard Questionnaires

• In theory,should not work.
• In practice,do not work.

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Insights from Psychology and Psychometrics on
Measuring Risk ToleranceJournal of Financial
Planning, April 2005
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Industry-Standard Questionnaires

• Too many bad questions.
• Too few good questions.

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Reliability

• Test Score True Score Error
• Reliability (r) Correlation between Test Score
  and True Score
• Error (SEm) StdDev x ?(1-r)
• Reliability (r) f(no of questions2)

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Risk Tolerance Characteristics

• 4 types physical, ethical, social and financial
• Normally distributed
• No sub-factors
• Males gt females by 1 sd
• Negative correlation with age, marital status and
  dependants
• Positive correlation with income, assets and
  education
• Advisers gt clients by 1 sd
• Clients estimates correlate .68
• Advisers estimates correlate .38

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Standard Methods
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Managing Risk Tolerance

• Assess your clients financial risk tolerance.
• Apply that assessment when formulating advice.
• Obtain your clients properly informed commitment.

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Gap AnalysisThe gap between

• risk required (the risk inherent in the return
  required to achieve goals)
• and
• risk tolerance (the preferred risk/return
  trade-off)

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Gap Analysis

• Bill and Suzie need an aggressive portfolio to
  achieve their goals, but
• Bills risk tolerance indicates he would normally
  choose a conservative portfolio and Suzies
  suggests a balanced portfolio.

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Linking Spreadsheet
Risk Tolerance
Risk Required
Methodology for comparing portfolio risk to
risk tolerance
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Expressing Scores as Growth Assets
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Comfort Zones
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Resolving the Gap

• Take more risk, and/or
• Lower goals and/or
• Invest more

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The Planning Process

• Assess risk tolerance.
• Determine risk (return) required.
• Gap analysis and resolution.
• Explain risk.
• Obtain properly informed commitment.

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Explaining Risk
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Explaining Downside Risk 20th 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
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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
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blah blah blah blah blah blah blah blah blah blah
blah blah blah blah blah blah blah blah blah blah
blah blah blah blah blah blah blah blah
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Explain the RisksLet me tell you about the
weather around here
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Short-Term Risk

• It does rain here!

Sample Portfolio 50 Defensive, 50 GrowthCash
10, Bonds 25, Intl Bonds 15,CAN Stocks 25,
US Stocks 15, Intl Stocks 10
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Portfolio Status(How often does it rain?)
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Falls Analysis(How heavy and for how long?)
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Top Ten FallsBig Wets
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Properly Informed Commitment
Clients better understand and are more
committed to your advice because

• risk tolerance was properly assessed,
• gaps were identified meaningfully,
• trade-off decisions were made knowingly, and
• the risks were explained in a manner that the
  client could understand.

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