Advisers who are de-risking client portfolios tactically, rather than to match clients’ risk tolerance, could be setting them up to fail, according to the principal of farrelly’s Investment Strategy, Tim Farrelly.
Farrelly says the process of portfolio construction does not need to change and will remain familiar to most financial planners, but the inputs and considerations that need to go into it are changing. First and foremost is an accurate assessment of a client’s risk tolerance.
“Risk profiling is incredibly important to your returns and it’s a two-pronged piece,” Farrelly says.
“It’s one, thinking about what your emotional risk tolerance is. There are a lot of very good tools out there; but also thinking about risk capacity, which is a new thing that we must think about more.
“The second piece is once you start using those tools, you start thinking, ‘Am I going to maximise returns or minimise the risk of failure?’ – or, [put] another way, ‘maximise the chance I’m going to meet my goals’.
“People are doing that and de-risking portfolios. If that’s done philosophically, that’s fine. If it’s being done tactically, to be reversed later on, it may be a problem because I think we could be in for a period of very low income returns and quite high returns from what we call growth assets.”
But, Farrelly says, “the portfolio construction process in this piece has not really changed”.
“Of course, the overlay of all of that is that in doing our portfolio asset allocation, I think we should be taking a more dynamic process than has been historically the case. But that’s a separate issue from these ones.”
Farrelly says matching a client’s risk profile to an appropriate asset allocation is a “largely mathematical” exercise.
However, “the judgement that has to come in there is, how bad might returns be over the next 10 or 15 years”, he says.
“You can look back on history, which gives you some guide, but there are better ways of doing it,” he says.
“But even if you say look, I think I’m going to get 8 per cent, but it could be as low as 2, that’s a huge improvement. And think, can I meet my goals at 2? That’s the idea of risk capacity: Can I accept the kind of shocks we’ve seen in markets over the past few decades?
“It requires thought and it requires calculation. It’s not trivial.”
Farrelly was a key presenter at the PortfolioConstruction Forum Conference 2012 in Sydney last month.
