To their credit, regulators have begun to be somewhat more open-minded about how to think about risk. When an investor opens an account with a financial adviser, they are required to complete a document called a new client application form. The form generally assesses the suitability of investments, based on how much an investor is willing to allocate to cash, bonds and stocks.
That all changed at the beginning of 2023 when new regulations known as Client Focused Reforms, or CFR, were enacted, giving primacy to risk tolerance and risk capacity. Risk tolerance is the psychological willingness to take on risk, whereas risk capacity is the financial ability to endure losses.
Where there had once been a percentage allocation targeted for cash, bonds and stocks, there are now percentage allocations for low, medium, and high-risk investments. Some firms have added two intermediate options: low/medium and medium/high. As such, there is now a five-step continuum that any given product or security might fall into when being rated for investor suitability as a component of an overall portfolio. That’s an important step forward, although it may be a bit discomforting for people who have spent the past generation or two looking at risk the old way.
If there was one thing that 2022 taught us, it is that a traditional portfolio diversified between stocks and bonds can no longer be relied upon in managing a client’s overall risk. Specifically, in the first nine months of 2022, both stocks and bonds were down by about 15 per cent – and by the time the year was over, most traditional 60/40 portfolios ended up down by double digits.
Part of the challenge is that many asset class correlations are increasing, meaning different types of investments are performing similarly to a greater degree. Diversification still works, but in a globalized world, it works less well than it used to.
Yet another part of the challenge is that most vehicles used by most people have average risk/return characteristics. In a world where most of your options involve taking medium amounts of risk, it becomes more difficult to offer true reliable risk reduction through diversification that fits client circumstances and potential market outcomes.
It’s perfectly fine to have a view on both portfolio construction and macro-level market outlooks, but discipline, open-mindedness, and preparedness are needed when encountering turbulent markets. Thinking in terms of a 60/40 split, or even 50/30/20 (the latter being an allocation to alternative investments) is linear thinking based on capital allocation. Alas, risk is not linear, and it is more useful to think of managing risk overall.
Regulators are coming to recognize this and are trying to capture more robust and meaningful attributes when accounts are opened to provide more detailed and accurate oversight of risk tolerance. Risk comes in many shapes and sizes. For example, it is widely accepted that the trade-off for more liquidity is often lower returns with more volatility. That said, not all clients are able to withstand the risk of having less liquidity. Whether or not to take that risk on is a decision that involves trade-offs that are viewed differently by different clients.
Rather than set asset allocation targets that can be adhered to within a reasonable range of deviation, the industry is moving to a risk budget approach where only certain allocations can be put into high and or medium-risk products, while remaining totally agnostic about the asset classes those products might fall under. For instance, while a traditional balanced portfolio would be a mix of asset classes, a portfolio constructed using the risk parameters set out in CFR might be 30 per cent high, 20 per cent medium/high, 40 per cent medium, and 10 per cent medium/low.
Individual products are then given a discrete risk rating and slotted into the five categories above. Getting products and risk ratings to align is the new normal in monitoring suitability. In the final example above, it would theoretically be possible for a client to have as much as 90 per cent in stocks and/or as much as 70 per cent in bonds and still fit the general risk profile. Depending on specifics of the products, it might even be possible to have that same overall risk rating – even with 100 per cent of the client’s money invested exclusively in alternative assets.
All told, the new approach allows for greater flexibility regarding portfolio construction. The concern, for many purists, is that it takes away from the focus on strategic asset allocation. As many people know, studies have shown that asset allocation is a primary determinant of both risk and return. It’s a brave new world. Risk and return are being assessed as considerations that are separate from asset classes. Not everyone will like this at first, but it likely improves the ability for advisers and portfolio managers to piece together combinations that offer superior risk-adjusted returns.
The related development is a new focus on both risk tolerance and risk capacity. This may well prove to be an even bigger challenge in the short term. Studies have shown that people say they have a strong tolerance for risk if markets are relatively stable. Thus, many people are ill-equipped to accurately assess their own tolerance and capacity for risk – especially if they have not encountered it in a meaningful way in their lifetime. The industry is moving forward. Progress is being made. But there is still much left to do.