The Challenge: Balancing Income and Risk

The Dilemma

Investors often grapple with two fundamental questions:

How much income?do they need from their investments? This pertains to their financial goals, lifestyle, and future needs.

How much of a risk?are they willing to take? Risk tolerance varies significantly among investors, influenced by factors such as age, financial situation, and personal temperament.

The Integrated Approach

The proposed framework seeks to address both income and risk considerations simultaneously. Rather than treating them as isolated factors, it recognises their interconnectedness. This approach allows for flexibility. It adapts to changing circumstances and investor preferences.

By considering income and risk together, advisors can strike a balance that aligns with each client’s unique situation.

Here’s how it works:

Holistic Assessment

• Instead of compartmentalising income and risk, the framework encourages a holistic assessment. It acknowledges that optimising one aspect may impact the other. For instance, seeking a higher income might involve accepting greater risk.
• Investors’ financial goals, lifestyle, and future needs play a crucial role in determining the desired income level. Simultaneously, their risk tolerance influences the acceptable level of risk exposure.
• By assessing both factors holistically, advisors can create customised solutions that align with individual profiles.

Behavioural Considerations

• Investors’ behavioural tendencies play a crucial role. Emotional biases, risk aversion, and cognitive biases influence decision-making.
• The framework accounts for these behavioural nuances, recognising that individual responses to income and risk are not purely rational. Behavioural tendencies impact their choices.
• Advisors must consider behavioural nuances when recommending investment strategies. For instance, risk-averse investors may prioritise stable income over high returns.

Dynamic Interaction

• Income and risk interact dynamically. A high-risk investment may yield substantial income initially but could lead to volatility. Conversely, a conservative approach might provide stability but limit income potential.
• Investors’ circumstances evolve. Their income requirements and risk tolerance may change due to life events or market conditions.
• The framework encourages scenario-based analysis. What if an investor’s income needs increase? How does risk tolerance adjust as retirement approaches? By modeling various scenarios, advisors can guide investors effectively.

Customised Solutions

Advisors can tailor investment strategies based on each investor’s unique profile. A risk-averse retiree seeking a stable income will receive different recommendations than a young professional aiming for growth.

This, however, is impossible to do by relying on growth and defensive exposure metrics combined with broad asset class views of portfolios as your definition of risk. Customisation must include a risk number. The following tools will solve this issue;

Value at Risk (VaR)

• Definition: VaR quantifies the maximum expected loss over a given time period at a specified confidence level. In other words, it answers the question: “What is the worst-case loss we can expect?”
• Calculation: VaR is typically expressed as a percentile of the loss distribution. For instance, a 95% VaR represents the loss level that will not be exceeded with 95% confidence.
• Application: VaR has become the standard approach for measuring market risk. Banks use it to allocate capital and manage risk exposure.
• Limitations: VaR does not consider extreme tail events beyond the specified percentile. It provides a point estimate but lacks information about losses beyond that threshold.

Conditional Value at Risk (CVaR)

• Definition: CVaR, also known as Expected Shortfall (ES) or Tail Value at Risk (TVaR), goes beyond VaR. It measures the average loss for losses exceeding the VaR threshold.
• Calculation: CVaR considers extreme events by calculating the conditional expectation of losses above the VaR level. It provides a more comprehensive view of tail risk.
• Interpretation: CVaR answers the question: “Given that we’ve exceeded the VaR, what is the average loss?”
• Advantages:Robustness: CVaR accounts for extreme scenarios, making it more robust.Risk Sensitivity: It captures the severity of losses beyond the VaR.Decision Support: CVaR helps in portfolio optimisation and risk management.
• Commonly Considered Levels: β-CVaR is evaluated at different confidence levels (e.g., 90%, 95%, or 99%).

Optimal Risk Number Solution

• Balancing VaR and CVaR: While VaR provides a threshold for risk tolerance, CVaR complements it by considering tail behaviour. Together, they offer a more complete picture.
• Portfolio Optimisation: Incorporating both VaR and CVaR in portfolio optimisation ensures a balanced trade-off between risk and return.
• Customisation: The optimal risk number solution varies based on an investor’s risk appetite, investment horizon, and specific goals.
• Holistic Approach: Consider VaR as the guardrail and CVaR as the safety nett. By integrating both, we navigate risk with greater precision.

In summary, VaR and CVaR are powerful tools for risk assessment. While VaR sets the stage, CVaR enriches our understanding of extreme outcomes. So, when crafting investment strategies, let’s waltz with VaR and tango with CVaR – achieving harmony in risk management!

Education and Communication

Advisors must educate clients about trade-offs. They can illustrate how adjusting income expectations impacts risk exposure and vice versa. Transparent communication fosters informed decisions.

A key component of this process is establishing client financial literacy and retirement literacy. Often, advisors assume that as clients age these scores grow. The latest research from the American College of Financial Services tells another story.

Conclusion

In summary, this framework encourages a dance between financial stability (income) and growth (risk). It acknowledges that investing isn’t just about numbers; it’s about aligning financial goals with individual preferences. By embracing this comprehensive approach, investors can navigate the complex landscape with greater clarity and confidence.

Australian advice faces the issues that risk is not used, risk profiling products are simplistic, and BeFi, although often discussed, is loath to be included in the fact-finding process. As a consequence, although this process is often discussed, advice needs tools, and the tools need standards to make them work.

Remember, investing isn’t just about numbers; it’s about aligning financial goals with individual preferences. So, the next time you ponder “How much income?” and “How much risk?” consider the interplay between the two—and perhaps even visualise it as a delicate dance between financial stability and growth.????

Interested in learning more? Check out other insights here

References:

Powell, R. (2007). Value at Risk and Conditional Value at Risk. The University of Western Australia

Rockafellar, R. T., & Uryasev, S. (2000). Optimization of Conditional Value-at-Risk. University of Washington

Uryasev, S., & Rockafellar, R. T. (1999). Some Remarks on the Value-at-Risk and the Conditional Value-at-Risk. Springer

Uryasev, S., & Zrazhevsky, G. (2014). Practical algorithms for value-at-risk portfolio optimization problems. Quantitative Finance Letters

Finance Strategists. (n.d.). Conditional Value at Risk (CVaR). Finance Strategists

Morrison-Smith, S., & Ruiz, J. (2020). Challenges and barriers in virtual teams: a literature review. SN Applied Sciences, 2(1096)

(Frontiers) Overcoming Challenges to Teamwork in Healthcare: A Team Science Framework.

Positive Psychology – Resilience Theory.