The Risk Tolerance Paradox, and what you can do about it

With a growing trend both globally and in Australia around low volatility, managed volatility, and portfolio risk management strategies, it is imperative that advisors and research consultants explore each strategy to uncover how different risks are being addressed. Identifying those techniques that are robust and able to address both diversifiable and systematic risks is likely to provide better overall results for investors and fund members.

Traditionally, portfolio construction and diversification across asset classes has been the major focus of risk management for the asset management industry. However, as the global financial crisis (GFC) highlighted, diversification alone cannot provide adequate protection in highly stressed markets. During the GFC, balanced and conservative portfolios experienced significant drawdowns, with some falling by more than 25%. This acutely highlighted the Risk Tolerance Paradox faced by investors approaching and entering retirement: Risk levels expected by investors over the long term are rarely the same as the risk levels they experience over shorter periods.

Historically, the industry’s preferred approach to overcoming portfolio volatility and large portfolio losses has been to stay invested, ride out the storm, average down, keep investing, and eventually growth will return and damage to the portfolio will be repaired. While this still holds true for the young, who have substantial time left before retirement, it may not be practical or realistic for those near retirement or already retired. As demonstrated during the depths of the GFC, many fund members acted against these principles and realised losses at the worst possible time.

The other traditional answer for those near or in retirement has been to de-risk the portfolio by reducing exposures to growth assets — an approach which has been reflected in the increased adoption of life cycle strategies. However, as retirees live longer and interest rates remain at historically low levels, life cycle or annuity solutions may lock in low levels of income or create a higher likelihood of exhausting savings early in retirement. Given current global market conditions and increases in average life expectancies, the answer will most probably include an element of continued exposure to growth, albeit with some explicit ‘managed risk’ or ‘managed volatility’ approach.

Wade Matterson of Milliman Australia stated: ‘With large demographic shifts well underway in the developed world, including Australia, investment strategies focused upon retirement are starting to resonate with local industry and retail funds. The growing issues of balancing longevity risk with the risk of permanent capital loss have continued to grow in importance for most of our clients.

‘Following several years of preoccupation with FOFA and MySuper, we have begun to see a strong increase in demand for retirement solutions that address key issues around risk management and retirement.

‘Our work with Plato Investment Management, who recently launched a Managed Risk Income Fund and Maritime Super, highlights the momentum that is building in the industry and the increased appetite to create solutions which address some of these issues.’

In a new Risk Tolerance Paradox paper published by Milliman, we explore the main reason for this paradox, and introduce a risk management strategy that seeks to solve the problem.