How to Determine the Risk Tolerance of Your Clients?
To GuidedChoice, asking a client questions about their lifestyle and personality is silly and irrelevant. We don’t need to know that their dog is named Atlas, that they’re afraid of fire extinguishers, or whether they’re financially conservative or aggressive. Instead, we get to know their current financial situation and extrapolate that to showcase the consequences of their actions, or inaction, in the form of their projected wealth and income at retirement. We prefer to present a range because we want the client to understand that retirement planning is uncertain, and best done on a recurring basis.
From there, we may recommend a different allocation, a more aggressive savings rate, or pushing retirement back a couple years. Regardless of what we recommend, we’ll show the new projected income range, allowing the client to compare his or her current track against the recommended one.
Our tool invites the client to change the variables and see the range of consequences, good and bad. With this system, we empower the client and help them make a more informed decision.
And we still don’t know whether they’re personally conservative or aggressive, or likes to garden, or to hang glide. Assessing our client’s risk tolerance is a top priority.
How does GuidedChoice arrive at the initial recommended allocation?
To recommend an initial point on the efficient frontier, we utilize a scoring model. We score possible ratios of wealth at retirement for that initial point and compare it to the wealth generated by the most conservative portfolio.
Our scoring is asymmetric. For short horizons, this makes the riskiest points on the frontier undesirable, but given long enough horizons riskier portfolios have time to make up for episodic shortfalls and score relatively better. Here are a few examples of our methodology in action.
Figure 1. Loss-averse scoring of relative wealth
Imagine a $1 allocated 66.6% stocks, 33.3% bonds. One possible simulation of the future wealth for that allocation in 20 years is that it grows to $5.32.
Now imagine a more conservative portfolio, one that is 70% cash, 20% bonds, and the rest in stocks. The same asset class simulation projects $1 growing to $2.15.
The ratio of those two is $5.32 / $2.15 = 1.35, which we plot on the X-axis. The point on the scoring curve with an X-value of 1.35 has a Y-value of +0.23, so for this simulation we would score the riskier portfolio with +0.23. We plot this on our scoring curve in Figure 2.
Figure 2. Score (vertical axis) of relative wealth ratio 1.35 = +0.23
Consider another possible simulation, where the riskier portfolio results in a projected wealth of only $1.44 and the conservative one results in projected wealth of $2.11. Now the ratio is $1.44 / $2.11 = 0.68. Since risk was not rewarded, we penalize this ratio with a score of -1.18.
Figure 3. Score (vertical axis) of relative wealth ratio 0.68 = -1.15
Now imagine if we repeat this indefinitely. In most of the simulations, the ratio of wealth is greater than 1, so the scores are positive. In some of the simulations, the ratio of wealth is less than 1, so the ratios are negative.
Figure 4. Average score of relative wealth ratio = +0.41
The result is a score for a 20-year time horizon.
Now we measure the scores for other possible allocations for a 20-year horizon. We’ll then recommend the allocation with the highest average score.
Notice that at a 30-year horizon, Risk level 6 had the highest mean score. At 25-years, Risk 6 also had the highest mean score. But by the time the horizon had shortened to 20 years, Risk 5 now had the highest mean score.
Why did Risk 5 have the highest mean score over 20 years, but Risk 6 have the highest mean score over 25 and 30 years? The reason is that Risk 6, a more aggressive allocation, is expected to endure a certain chance of bad outcomes. Given a long enough horizon – in this case 25 years or longer – our scoring model decided that Risk 6 is worth the risk. Given a horizon of only 20 years, our scoring model decided that Risk 6 wasn’t worth the risk over Risk 5.
When applying this scoring method across all possible horizons from 1 year and longer, the result is a recommended sequence of portfolio risk that declines as the horizon shortens, describing a “to” glide path.
At GuidedChoice, we do all of this behind the scenes to provide your clients with the best strategy, no matter their situation. So while we may not know what their dog’s name is, we do know how to make their money work hardest for them.
Book time with our team to learn more about GuidedChoice or to schedule a demo. We look forward to helping your participants create the future they want.
To learn more about our rigorous and proprietary methodology, architected by Nobel Laureate, Dr. Harry Markowitz, click here.