How do you determine the right amount of risk for a person's savings? How do you decide on the risk to reward ratio? Is it based on your experience, a questionnaire, or is there a formula?
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There isn’t one simple answer to this. In truth for me, it is based on trying to understand the client as well as I can, to determine what is the appropriate level of risk for them based on their goals, attitude to risk and return, and investment experience. Some clients want to maximise the chance of meeting their lifestyle goals with minimum risk while others would prefer to maximise their wealth without taking stupid risks.
As background you should understand that the assets that produce the highest returns over the long run, have the greatest variability in returns, and they may have the greatest frequency of periods with negative returns. Even within an asset class there can be a huge difference in risk/return based on underlying investment strategies employed. Within equity you can invests in a portfolio managed to minimise volatility at one extreme to another investing with funds the invest in more speculative investments (private equity/ microcaps) or using leverage to maximise chance of outperforming.
In the first instance we try and understand from a client what they want from their money. The timeframes at which they need to access the funds may have a big bearing in terms of thinking about the right asset classes as well as the right investment structure.
Its also about stage in life – people who are younger, saving a lot more than they spend can and not looking to access their savings for a long time, can take a lot more risk than someone at or very close to retirement, who needs to draw down on their capital to fund lifestyle expense.
We also use a questionnaire to try and understand the client’s attitude to investment risk. This asks questions that deal with both the clients experience in investing as well as their attitude to risk, how they think they would react with a large fall in portfolio value, how comfortable are they with negative returns. I try to get the clients to talk to me as they respond to the questions to get extra colour around the way they are thinking.
It’s also trying to understand how much risk the client needs to run to be able to meet their goals. In some situations, clients may need to take considerable risk to be able to try get the returns required to meet their goals, or alternatively need to constrain their goals (generally reduce amount budgeting for lifestyle expense). For clients that need to take risk to meet goals we may look at things such as lower volatility funds to get the growth exposure, to help constrain the amount of risk being run. Generally, however if a client will easily meet their goals, they will have a greater propensity to take a higher level of risk
The trouble with just formulas/ questionnaires, is it doesn’t relate back to the client. I had a client whose questionnaire is moderate risk tell me because they have a paid off house, 10 years to work in a stable job and haven’t got any gearing that 100% equity investments feels conservative for them at their stage life.
It really is a case of trying to work with the client to assess what is appropriate for them.
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