Managing Risk Tolerance

1. ManagingRisk Tolerance Geoff DaveyCo-Founder and CEOFinaMetrica Pty Limited

2. The Meaning of“Risk Profile/Profiling” • An assessment of an individual’s risk tolerance. or • An assessment of the risk(/return) in an investment strategy (thought to meet the clients needs.)

3. Managing Risk Tolerance • Assess your client’s financial risk tolerance. • Apply that assessment when formulating advice. • Obtain your client’s properly informed commitment.

4. Whatisrisktolerance?

5. Risk ToleranceHow much risk I choose to take.(a psychological construct) • Risk CapacityHow much risk I can afford to take.(a financial construct)

6. What’s yourrisk tolerance? Uh?

7. Assessment Techniques • Interview-based(subjective clinical judgements) versus • Test-based(psychometric instrument)

8. Psychometrics • Psychology and statistics • Science of test construction • Standards for evaluating tests • Validity, reliability and accuracy

9. Test Development Pool of Questions Sample Questionnaire Useability Trials • Understand? • Answer? Norming Trials Statistical Analysis • Validity? • Reliability? • Accuracy?

10. 20+Plain EnglishQuestions ScoringAlgorithms “Norms”Database Risk ToleranceReport PsychometricRisk Tolerance Test

13. Risk Profile Report

14. “Know The Client” • Compliance • Marketing • Sales

15. Industry-Standard Questionnaires • In theory,should not work. • In practice,do not work.

16. Insights from Psychology and Psychometrics on Measuring Risk ToleranceJournal of Financial Planning, April 2005

17. Industry-Standard Questionnaires • Too many “bad” questions. • Too few “good” questions.

18. Reliability • Test Score = True Score ± Error • Reliability (r) ~ Correlation between Test Score and True Score • Error (SEm) = StdDev x (1-r) • Reliability (r) ~ f(no of questions2)

19. Risk Tolerance Characteristics • 4 types: physical, ethical, social and financial • Normally distributed • No sub-factors • Males > females by 1 sd • Negative correlation with age, marital status and dependants • Positive correlation with income, assets and education • Advisers > clients by 1 sd • Clients’ estimates: correlate .68 • Advisers’ estimates: correlate .38

20. Standard Methods

21. Managing Risk Tolerance • Assess your client’s financial risk tolerance. • Apply that assessment when formulating advice. • Obtain your client’s properly informed commitment.

22. Gap AnalysisThe “gap” between … • risk required (the risk inherent in the return required to achieve goals) and • risk tolerance (the preferred risk/return trade-off)

23. Gap Analysis • Bill and Suzie need an aggressive portfolio to achieve their goals, but … • Bill’s risk tolerance indicates he would normally choose a conservative portfolio and Suzie’s suggests a balanced portfolio.

24. Linking Spreadsheet* Risk Tolerance Risk Required * Methodology for comparing portfolio risk to risk tolerance

25. Expressing Scores as% Growth Assets

26. Comfort Zones

27. Resolving the “Gap” • Take more risk, and/or • Lower goals and/or • Invest more

28. The Planning Process • Assess risk tolerance. • Determine risk (return) required. • Gap analysis and resolution. • Explain risk. • Obtain properly informed commitment.

29. Explaining Risk

30. Explaining Downside Risk: 20th Century Your Financial Plan Blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah Negative return 1 year in 5. blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah blah

31. Explain the Risks“Let me tell you about the weather around here …”

32. Short-Term Risk It does rain here! Sample Portfolio: 50% Defensive, 50% GrowthCash 10%, Bonds 25%, Int’l Bonds 15%,CAN Stocks 25%, US Stocks 15%, Int’l Stocks 10%

33. Falling33% Rising46% Recovering21% Portfolio Status(How often does it rain?)

34. Depth of Fall Length of 10% 20% 33% Fall < to to to => Total (Months) 10% 19% 32% 49% 50% 1 36 36 2 5 5 3 3 1 4 4-6 6 6 7-12 1 1 2 13-24 >24 1 1 Total 54 51 2 1 Falls Analysis(How heavy and for how long?)

35. Top Ten Falls“Big Wets”

36. Properly Informed Commitment Clients better understand and are more committed to your advice because • risk tolerance was properly assessed, • “gaps” were identified meaningfully, • trade-off decisions were made knowingly, and • the risks were explained in a manner that the client could understand.

37. www.risk-profiling.comwww.planplus.comfree 30-day trial