INVESTING
Among the other problems with the risk score approach is that clients with vastly different circumstances can end up owning the same portfolio — all because ( wait for it ) the risk score is the same .
ing portfolio is completely disconnected from the client ’ s financial plan .
Among the other problems with this approach is that clients with vastly different circumstances can end up owning the same portfolio — all because ( wait for it ) the risk score is the same . A 25-year-old should invest aggressively because of her circumstances , not because of her personality . She has 40 years until her drawdowns really matter for her consumption goals . A 75-year-old should invest more conservatively because of her needs and circumstances : Her near-term losses can ’ t necessarily be recovered from her nest egg as it is being consumed .
Yet both of these clients can end up in a 60 / 40 portfolio if they have the same risk score , in which case their differences become irrelevant .
Besides these obvious flaws , a litany of behavioral finance research studies have emerged pointing out more flaws in the risk-scoring approach .
The Behavioral Backdrop
There are myriad well-documented behavioral issues involved in risk-tolerance questionnaires and the scores that result . Risk scores , for one , fail to distinguish the degree of risk tolerance on a granular or individualized level ( even if we accept the concept of volatility as risk ). That means most clients end up in the “ moderate ” risk tolerance bucket . The result is a onesize-fits-all approach — the polar opposite of the customization that clients demand and advisors want to offer .
Everyone claims to be a long-term investor until they run into their first patch of poor performance , when they suddenly become obsessively interested in today ’ s / this week ’ s / this quarter ’ s returns . We call this poor emotional time travel .
The Solution
The alternative is to connect the client ’ s financial plan ( not the risk score ) to a custom portfolio . Instead of defining risk as volatility , we should define it as “ not having what you need , when you need it ” and then build portfolios to minimize that risk . This is a significant leap forward for goals-based wealth management .
We believe that an investment policy process that better balances a target return , the time horizon and risk tolerance will lead to better outcomes . We combine that process with our platform at Nebo Wealth using our pioneering portfolio optimization engine . The platform lets an advisor build a perfect-fit portfolio for each client at every stage of life . This is all done in an open architecture platform allowing you to use your own firm ’ s capital market assumptions and preferred investment building blocks ( ETFs , individual stocks or mutual funds ). If your client ’ s goals and objectives change , their portfolio will seamlessly evolve too . You no longer need to rebalance to a static allocation . Instead , you reoptimize according to the dynamic nature of the capital markets and client circumstances through a systematic , repeatable process for a new perfect-fit allocation .
A Leap Forward In Goals-Based Investment Management
Financial planning tools have done a great job of helping advisors build out the cash flows necessary to achieve a client ’ s long-term goals . But these tools have also ventured into the world of asset allocation . And here , our view is that they fall woefully short . Again , the client ’ s risk score has ended up being the primary determinant of a client ’ s portfolio , and we think there ’ s a better way .
JAMES MONTIER , a behavioral finance expert , is the senior investment strategist , asset allocation for GMO .
MARTIN TARLIE is the product lead for Nebo Wealth MATT KADNAR is the sales lead for Nebo Wealth .
This article is an abstract of a recently published white paper , “ The Perils of Outsourcing Asset Allocation to a Risk Score .” To read the full report , download at www . nebowealth . com / theory / the-perils-of-outsourcingasset-allocation-to-a-risk-score .
46 | FINANCIAL ADVISOR MAGAZINE | JULY / AUGUST 2024 WWW . FA-MAG . COM