Expressing Risk in a Client's Portfolio

Advice documentation does not convey risk to clients at all.

An effort is made to establish a risk profile for a client, but then we have no expression of risk for the client other than the problematic Standard Risk Measurement (SRM) system and the classification of assets into the broad categories of "Growth" or "Defensive" in nature. Thus there is no true reconciliation of the "recommendations" in the advice documentation and the associated risk generated with the risk profile of the client. This article speaks to this conundrum.

The current methodology for expressing risk in a client's portfolio is a combination of these two elements;

• to classify the investments in a portfolio as either "growth" or "defensive"

• to express the risk via an "SRM" which represents the number of negative returns over twenty years. It is then expressed as "very low" to "very high".

The classification system of "growth & defensive" (G&D) does not express risk and speaks purely to return. Most view a "growth" asset as something that goes up in value (FSC). There is no formal definition of "defensive" assets. By formal definition, their ability to define risk does not exist.

Here are some of the main limitations of the G&D approach:

The classifications:

• are based on historical performance and may not accurately reflect future performance. Figure 1 speaks to this valuation reality.

• are broad and may not capture the nuances of individual investments within each asset class. Particularly as there are no standards around classification.
• are not comparable across different investment options or funds, as the methodology used to classify assets may differ.
• do not take into account an investor's risk tolerance or investment objectives. Nor their holistic goals & objectives.
• do not consider the path-dependent nature of drawdowns, which can have a significant impact on an investor's portfolio.
• do not account for the possibility of a sudden and significant drawdown that may occur outside of the growth or defensive asset class.
• do not consider the impact of inflation on the value of defensive assets over the long term.

Overall, while the "growth" and "defensive" classifications of assets can provide some insight into an investment's risk and return characteristics, they should not be relied upon as the sole measure of risk.

The number of negative returns over twenty years is a drawdown measure. Which is an expression of risk but limited as it only points to one aspect. There are five other aspects to the drawdown exposure metric;

• Peak-to-trough drawdown: This measures the percentage decline from the highest point to the lowest point of an investment or portfolio over a specific period.
• Rolling drawdown: This measures the percentage decline from the highest point to the lowest point of an investment or portfolio over a rolling period, such as a month or a quarter.
• Absolute drawdown: This measures how much an account value has gone below the initial deposit.
• Maximal and relative drawdown: Maximal drawdown measures the maximum percentage decline from the highest point to the lowest point of an investment or portfolio over a specific period, while relative drawdown measures the percentage decline from the highest point to the lowest point relative to a benchmark.
• Expected shortfall: This measures the expected loss in the worst-case scenario, given a specific level of confidence.
• Conditional expected drawdown: This measures the expected loss in the worst-case scenario, given a specific level of confidence, and takes into account the path-dependent nature of drawdowns.

None of these other variants are spoken to.

The default Australian SRM has some limitations. Here are some of the main limitations

• This metric relies on historical data and does not necessarily serve as an indicator of future performance.
• It is founded on the anticipated frequency of negative annual returns over a 20-year timeframe, which may not accurately mirror an investor's risk tolerance or investment objectives.
• It does not factor in the extent of negative returns, which can be substantial and exert a more pronounced influence on an investor's portfolio than the frequency of negative returns.
• It assumes a consistent probability of negative returns over time, which may not hold true.
• Comparability across distinct investment options or funds may be compromised, as the methodology for computing the standard risk measure can vary.
• It does not accommodate the potential for an abrupt and substantial drawdown outside the 20-year period.
• The path-dependent nature of drawdowns, which can profoundly impact an investor's portfolio, is not taken into consideration.

Overall, while the default Australian SRM can provide some insight into an investment's risk, it should not be relied upon as the sole measure of risk. Investors should consider other drawdown risk measures and take a comprehensive approach to risk management.

Conclusion

Current approaches fail consumers and contribute to the image of advice not offering sufficient value for consumers to engage with it.

We propose that clients need risk to be expressed in dollar terms and as a single number that is easily understood but also communicates the risk involved in ALL its forms. In our follow-up article, we will speak about our approach to resolving this issue.

You can check out our detailed look at drawdowns at: https://medium.com/@walshbenjamin007/introduction-ec1317fb6dd0