Financial advisers generally use, in addition to the investment objective and time horizon indicated by the client, a risk tolerance questionnaire to determine an investor’s asset allocation or the percentage he invests in. must invest in stocks, bonds and cash.
But these questionnaires, often referred to as RTQs, are nothing more than black boxes that spit out an asset allocation without highlighting the benefits and costs of the portfolio under consideration, explains Javier Estrada, professor at IESE Business School.
âDetermining the asset allocation of a portfolio is one of the most important decisions investors make,â said Estrada. âFinancial advisers typically deal with this problem by handing individual investors an Investor Questionnaire, which is a black box that suggests a portfolio without any supporting hunch. The problem with a black box is that if an investor doesn’t fully understand why an asset allocation is right for them, they are unlikely to stick with the portfolio during the inevitable hard times they will face. .
To address this shortcoming, Estrada has created a new kind of asset allocation tool – he calls it the Gain-Pain Index or GPI – which can be used by financial advisers with their clients. Read: The Gain-Pain Index: Asset Allocation for Individual Investors (and Others?).
According to Estrada, his GPI aims to make a client’s asset allocation process more intuitive and it allows a financial advisor to highlight the relevant tradeoffs of different portfolios (asset allocations).
The methodology, as with most RTQs, takes into account the risk aversion of the investor and the expected holding period for the portfolio. But, more importantly, he also views risk in a more holistic way than just volatility (which is what most RTQs focus on), Estrada said.
For example, in his model, the gain is given by the expected return of each portfolio and the pain by three sources of risk: volatility, the probability of suffering a loss, and the size of the loss, the last two of which are combined into one variable, the expected loss. âThese last two variables are a much more intuitive way to assess risk than volatility,â Estrada said.
And advisers who might consider using Estrada’s GPI should take comfort in knowing that his idea is based on well-established research.
For example, the pain component of the GPI is in part inspired by the misery index developed by Arthur Okun, chairman of the Council of Economic Advisers during part of the Lyndon Johnson administration. âThe pain component needs to be assessed taking into account an investor’s risk aversion coefficient, and (my) article shows a way to estimate the latter through a bet,â he said. .
Moreover, the idea behind the GPI, Estrada writes in his article, is not entirely different from Harry Markowitz’s 1959 research on approximations of the mean variance of expected utility.
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So here is an example of how GPI works, at least on paper.
The GPI takes into account, using complex calculations, the gains and disadvantages of different portfolios (asset allocation), as well as an investor’s risk tolerance, the expected holding period of the portfolio, the probability of incur a loss during the expected holding period of the portfolio and the average loss.
And the result, the GPI, finally highlights the trade-offs involved between the expected return of the different portfolios on the one hand, and the volatility, the probability of suffering a loss and the average loss of these portfolios on the other hand. And the goal would be to select the portfolio with the highest GPI, or at least understand the trade-offs associated with not selecting the highest GPI.
In one of the many tables in her article, Estrada looked at 21 asset allocations with different proportions of stocks and bonds and a 20-year holding period and found that the optimal asset allocation was 95% stocks and 5% bonds.
According to Estrada, the main advantage of such a table is that it can be presented to an investor, who would be able to assess the expected gain (return) and pain (volatility, probability of loss and average loss). different asset allocations.
“An investor might observe, for example, that portfolios with at least 70% stocks have never lost purchasing power over 20-year periods, which, if history is any guide, implies that the expected loss (corrected for inflation) for these relatively aggressive portfolios is 0, âhe writes in his article.
It should be noted that the GPI model offered by Estrada is used to determine the optimal asset allocations for 21 countries and the global market, for different holding periods and levels of risk aversion, and generally gives portfolios a bit more conservative than those determined by standard mean-variance optimization.
So what do Estrada’s labor experts say?
“It’s an interesting idea, but I wonder how many financial advisers would give up what they’re doing and use it?” Asked John Grable, professor at the University of Georgia.
Granted, financial advisers are unlikely to give up on what they are doing. But they should consider doing so given the results of a 2016 study.
âPlanPlus reveals a worrying lack of quality risk tolerance questionnaires (RTQs) and support tools for financial advisers,â wrote Michael Kitces, editor of the Nerd’s Eye View blog.
“In part, this seems to be driven by the fact that regulators articulate the principle of ‘know your client’s risk tolerance’, but provide little guidance on how to proceed to ensure that it is.” just. And to a large extent, the problem stems from the fact that neither regulators, academics, nor advisers themselves even agree on the key factors of a client’s “risk profile” that need to be assessed. in the first place.
So, given the imperfect state of RTQs, advisers might well consider testing the GPI. At the very least, the GPI could be used as a tool to confirm or adjust a client’s current asset allocation. And what would be the harm in doing more due diligence?