Articles

Mar 11

Goal-Based Risk

Posted by Peter Marmara-Stewart at Monday, March 11, 2019

It is common in the finance industry to use people’s subjective feelings about risk as part of the process to develop a particular investment strategy. Risk tolerance questionnaires are used to quantify these vague feelings and map people to a range of conservative, moderate, or aggressive portfolios. Goals-Based Risk addresses the shortcomings of this approach and instead focuses on investment goals as the lodestar in the financial planning process, while still being mindful of the strong emotional reactions people have to risk and volatility.

Taking a New Perspective on Investor Risks
Investors face risks from a variety of sources. Risk is often equated to variance in returns, referred to as Market Risk (or unsystemic risk). This risk can be mitigated by portfolio diversification and well-known optimization methods. Goals-Based Risk highlights another equally important source of risk that comes from people making unwise choices, termed Behavioural Risk. This risk results from people acting as their own worst enemy and making poor investment decisions that can potentially reduce their long-term earnings. Examples of self- defeating behaviour include people trying to time markets, chasing returns, and panic selling. Behavioural risk emerges when people deviate from principled investment strategies and make impulsive choices. This resulting “Behavioural Gap” can cost investors about 1.0-2.5% per year. Simply put, investors meddling with their portfolios typically make their performance worse, and as such investors can be a menace to themselves when they make emotional decisions.

Behavioural risk should not be ignored, and it cannot be solved with the well-known approaches that are used to diminish market risk—behavioural risk requires different kinds of solutions.

Advisors as Behavioural Coaches
The Goals-Based Risk framework posits that a major value of financial advisors is not just in the portfolio construction process, but in the financial planning process, and furthermore in their bolstering investor’s risk resilience. Effective advisors act as behavioural coaches—think of this as a kind of therapist that is paid proportionally to their assets under management. As behavioural coaches, advisors can cultivate calm, thoughtful, and goal-directed behaviour that prevents their clients from acting as their own worst enemies while investing. This framing helps align the incentives of investors and advisors, and further highlights the value of good financial advice in helping clients both make effective plans and exercise the discipline to execute their plans diligently over the long haul.

An Integrated Investment Planning Approach
Goals-Based Risk provides a framework where the objective characteristics of an investor determine what makes for a good financial plan and investment strategy, and the subjective characteristics highlight the framing, interventions, and nudges that are useful to help investors stay the course. The objective characteristics correspond generally to an investor’s risk capacity, while the subjective characteristics capture the core investor psychology that drives behavioural risk. Successful investing demands dealing with both effectively. Goals-Based Risk does so and provides a detailed investor profile, including insights about a person’s risk preferences and their risk reactivity (i.e., how market volatility affects their risk preferences over time). This expanded profile supports tools that give advisors timely information about what interventions are most effective and when they should be implemented to help investors stay on track.

Putting Risk Preferences in Their Proper Place
An investor’s financial goals—not emotionally driven risk preferences—should determine what investments they have. For investors, whose risk preferences are stable and broadly consistent with their goals and an efficient portfolio that serves those goals, there is little conflict and their experience should be smooth. For investors, whose preferences are labile and/or inconsistent with a strategy required to reach their goals, there is a special need for a financial advisor to act as a behavioural coach. These “conflicted” investors may need more feedback and guidance, which provides an opportunity for advisors to be particularly effective. These investors, with proper behavioural coaching, can constructively adjust and bring their investment strategy in-line with their feeling-based risk preferences. For example, investors can increase their savings rate, give themselves more time before making withdrawals, curtail their goals, and/or find ways to understand and deal with the ups-and-downs that will inevitably occur.

Risk preferences still play a role in all of this, but not by directing a person’s investment choices. Instead, risk preferences highlight decision frames and interventions that help a person stay committed to investment strategies that serve their long-term financial goals.

By Ryan Murphy and Steve Wendel, Morningstar Research Paper