Clients often overestimate risk tolerance

[Bylo Selhi]

Clients often overestimate risk tolerance

"Studies of investment behaviour show that the financial markets are not the cause of investment plan failure; rather, it is the investors themselves who cause the failures." That's taken from an excellent new book, All About Asset Allocation. It's by CFA Richard Ferri, with a foreword by William Bernstein, author of The Intelligent Asset Allocator...

Ferri warns that risk-tolerance questionnaires banks and fund companies are fond of dispensing can be misused. Generally, people overestimate their tolerance for risk. They may think they'd hold the course if U.S. stocks plummet 40% in a year. But if it actually happened how many would panic and sell rather than suck it up and "rebalance" by buying more at now-bargain prices?...

As Ferri puts it: "It does not matter how low your level of risk is, as long as you know what it is."

Being conservative and setting a client's asset mix slightly below their maximum risk tolerance means they'll be more likely to stay the course. Being overly optimistic and setting their mix higher than their true risk tolerance runs the danger they'll bail from a plan at the worst possible time. "Investing at a maximum risk tolerance-level is rarely appropriate for anyone who is in retirement or nearing retirement," Ferri writes....

[Shakespeare]

Didn't know Ferri's book was out.

Unfortunately, my local Chapters doesn't have a copy. So I will order one if I can figure out what else to get for free shipping.

[That's like the wife that came home after the sale with her arms full of packages, bubbling about how much money she "saved".]

..or maybe drop an e-mail to the relatives....

[Bylo Selhi]

..or maybe drop an e-mail to the relatives....

Or maybe drop an e-mail to Ferri, offering to post a review on your site -- if only you had a copy to review

(It's worked for me with other authors. See the bottom of http://www.bylo.org/ieducate.html )

[Shakespeare]

The relatives have the e-mail. There are copies in Calgary, if my niece wants to take a look.

[dakota]

The relatives have the e-mail. There are copies in Calgary, if my niece wants to take a look.

Hey this was well before Christmas...you must know someone who would give it to as a present?

Clients often overestimate risk tolerance

I think it matters a whole lot how long a client has been investing and how old he/she is. I have a good handle on my risk tolerance!

[Shakespeare]

I got it for Christmas and have read most of it.

Ferri is a slicer-and-dicer. He also suggests slicing bonds. I have switched 5% of the portfolio from PH&N ST B&M to PH&N High Yield.

[dakota]

I have switched 5% of the portfolio from PH&N ST B&M to PH&N High Yield.

Interesting...I used to own a US high yield bond fund and a US convertible bond fund wich are not available in Can. This was in '02 during the recovery and did really well untill the C$ started eliminating a lot of my gains and I got out. I don't have 50,000 sitting around but would they accept 25,000 and split it between the two funds?

[parvus]

Rick Ferri:

They may think they'd hold the course if U.S. stocks plummet 40% in a year. But if it actually happened how many would panic and sell rather than suck it up and "rebalance" by buying more at now-bargain prices?...

And if it were Nortel?
I guess it depends whether it was a glamour stock or a value stock ... can one go further, and talk about glamour indexes and value dexes?

The problem I find — not that Ferri is guilty of this, and I confess I haven't read him — is that U.S. investors, their advisors, and their market commentators live in a mirror world, largely ignorant of what happens outside. Hence, in one of my annoying e-mail subscription adjuncts to the free access to a website, Louis Navellier rabbits on about Canadian oilsands for U.S. investors. I won't say never, but I suspect most of the bargain run-up is done. Now it's a question of ROE. So much for market efficiency.

[Shakespeare]

Now it's a question of ROE.

And getting enough steel, natural gas, and pipefitters into Fort Macmurray.

I wouldn't be surprised to see some cancellations.

[la principessa]

Having taken a few risk tolerance tests that yielder pointed me to in another thread, I have to say that they're outdated, they beg questions, and most importantly, don't capture crucial information.

For instance, we used to live in a buy-and-hold environment where there were penalties for redeeming funds. That's a thing of the past given the ever-increasing variety of ETFs. But a bank advisor wouldn't be recommending those...

Also, there are time-horizon questions such as "what's this money for?" and "when will you need it?" If you say you want it for a down payment on a house, you'll automatically be directed to money market funds. But you can't get there from here...

You'll be asked about how comfortable you are with large paper losses, but at the same time, you're tempted by the juicy potential gains the charts show. (This may be where people naturally get greedy and underestimate their tolerance.)

What's needed is an overhaul so these questionnaires don't lead the witness, and also take into consideration that people may buy and sell more frequently to ameliorate the downside. Lastly, boomers who have benefited by the real estate market may have more play money and view it differently.

[dakota]

I got it for Christmas and have read most of it.

Ferri is a slicer-and-dicer. He also suggests slicing bonds. I have switched 5% of the portfolio from PH&N ST B&M to PH&N High Yield.

Short Term Bond & Mortgage Fund
Investment Objectives
To provide relatively high yields and stability of capital by investing primarily in a well-diversified portfolio of short-term fixed income securities issued by Canadian governments and corporations, and first mortgages on property located in Canada.


Investment Returns (%): Series A Units
As of December 31, 2005

YTD 1 yr. 2 yrs. 3 yrs. 5 yrs. 10 yrs.

2.1 2.1 3.4 3.8 5.2 5.7

Annualized compound rates of return on periods over 1 year.



Third Quarter Commentary - September 30, 2005
The Short Term Bond & Mortgage Fund returned -0.2% in the third quarter and 4.2% over the past year.

The Fund outperformed the market over the quarter, as we correctly positioned the portfolio for a rise in short-term bond yields. The actions of the Bank of Canada have a particularly important influence on these bonds and, as a result, the increase in the overnight rate in September and the message from the Bank that further increases are likely, led to these higher yields. We will continue to maintain a defensive structure for the Fund, in anticipation of reinvesting at higher yields over the next six months or so.

We continue to add yield by investing almost 50% of the Fund in higher-quality corporate bonds, and almost 30% in mortgages (both CMHC-guaranteed and non-guaranteed commercial mortgages). We increased the Fund's allocation to these sectors in the quarter, taking advantage of the steady supply of attractive new corporate bond issues. Also, mortgages represents one of the best opportunities to add steady income to the portfolio

That is not a very high return shakes, is this correct?

[Shakespeare]

The short-term fund numbers willl be low in a low rate environment.

From Globefund for PH&N High Yield:

Code: Select all

Returns as of December 31, 2005
Fund    Group Avg    Index*
1 month    0.91%    0.71%    0.71%
3 month    0.13%    0.22%    0.22%
6 month    1.25%    0.16%    0.12%
1 year    5.40%    1.43%    1.35%
3 year    9.80%    7.44%    7.42%
5 year    8.88%    6.29%    5.66%

They beat the index handily.

[dakota]

I don't think TDW sells the PH&N High Yield fund because it is not in their line-up whereas Short term Mortgage and bond fund was.

[Bylo Selhi]

I don't think TDW sells the PH&N High Yield fund because it is not in their line-up whereas Short term Mortgage and bond fund was.

From WebBroker order entry:

Code: Select all

PHILLIPS, HAGER & NORTH HIGH Y      Front Load      High Yield Bond      PHN280

Note the "front load." That's a 2% or 2.5% fee applied by TD WH to PH&N funds. Other brokers allow you to buy PH&N funds with no loads or other charges.

Now, why would anyone want to buy PH&N funds from TD WH when you can buy directly from PH&N? (The old RRSP foreign content rules no longer apply so there's no longer that reason to consolidate RRSPs.)

[dakota]

I was going by the symbol lookup and it only shows 13 PHN funds and the high yield bond is not among them, when I specify high yield bond it says that there is no mutual fund symbol for my request.

[yielder]

For instance, we used to live in a buy-and-hold environment where there were penalties for redeeming funds. That's a thing of the past given the ever-increasing variety of ETFs. But a bank advisor wouldn't be recommending those...

But not necessarily because of cost. The fact that there are low-cost alternatives doesn't mean that you shouldn't buy and hold.

If you say you want it for a down payment on a house, you'll automatically be directed to money market funds. But you can't get there from here...

It depends on the time frame. If you say that you plan to make the down payment within 5 years, you'll get steered to money market funds. The assumption is that you have the capital and should protect it. If you don't have the capital and want to make a downpayment within five years, you can't get there from here without taking on a great deal of risk. That option isn't available in the questionnaires.

You'll be asked about how comfortable you are with large paper losses, but at the same time, you're tempted by the juicy potential gains the charts show. (This may be where people naturally get greedy and underestimate their tolerance.)

The questions are interconnected. For example, if you say that you do not want to risk capital and then answer all of the following risk/return questions choosing the highest ratio, those answers are ignored. I haven't run through the questionnaires to try and figure out how the cross-checking works but I can guess at some of it. If you say that you have the maximum gross income, you're probably allowed a greater equity bet. If you are also young, you're probably allowed an even bigger equity bet. If you're middle-aged or older, maximum assets and maximum gross income, you may have a slightly aggressive balanced portfolio.

people may buy and sell more frequently to ameliorate the downside.

The downside is ameliorated by constructing a properly diversified portfolio not by market timing.

Lastly, boomers who have benefited by the real estate market may have more play money and view it differently.

Only if they cash in. Otherwise, it's just a wealth effect unless they have cash flow. If they have the cash, there's nothing to stop them from going through the portfolio construction exercise and having a play money portfolio as well.

These online questionnaires are far from perfect. They don't, for example, take into account that you may have a large and very secure defined benefit pension that would allow you to be 100% in equities. Notwithstanding, they are a better first step than winging it.

Just out of curiosity, what did the questionnaires suggest that you do?

[la principessa]

Just out of curiosity, what did the questionnaires suggest that you do?

BMO
0% cash
45% FI --- 26% Can Bond, 9% World Bond, 10% Mortgage
55% Eq --- 30% Can Equity, 13% U.S. Equity, 12% International Eq

Edmond Financial
"Balanced with above average risk tolerance"
--- 26% Can FI, 14% Global FI, 22% Can Eq, 15% U.S. Eq, 13% Global Eq, 10% Alternative Eq

TD Waterhouse
"Balanced Growth Investor"
--- Safety 5%, FI 30%, Can Eq 17%, U.S. Eq 27%, Int’l Eq 21%

Given that I've had a nasty cold and markets were closed yesterday for Martin Luther King Day, I had a chance to mull and make changes. I played my "cherry picking sectors" today, but only with 60% of the portfolio. I'm now looking at no-load, tax-exempt municipal bond funds and broader market index ETFs to add stability.

[Shakespeare]

[wallstreetamigo]

Having taken a few risk tolerance tests that yielder pointed me to in another thread, I have to say that they're outdated, they beg questions, and most importantly, don't capture crucial information.

What's needed is an overhaul so these questionnaires don't lead the witness, and also take into consideration that people may buy and sell more frequently to ameliorate the downside. Lastly, boomers who have benefited by the real estate market may have more play money and view it differently.

I agree. As an advisor, I see the problem is that questionaires are often used as the sole means of identifying a client's risk tolerance when, in reality, they should be used to guide the advisor to ask the right questions and educate the client. Risk tolerance is all about what would the client do in a worst case scenario and what impact would that have on their financial situation, not what possible return are they looking for. Risk can be somewhat controlled, returns are impossible to accurately predict. Any advisor worth his or her salt knows that understanding and explaining risk properly is the only way we can help clients control the crazy urge to do the wrong thing at the wrong time. On the plus side, using questionaires properly helps calm clients when things go against them because it allows the advisor to reinforce the reasons behind the strategy and refresh the clients memory around the risk conversation. It's all about proper education and managing expectations. Just my $0.02.

[Alpha Dog]

While risk tolerance questionnaires do have their place, the piece that they can't account for is the emotional factor. People know the "right answer" to a question like: "What would you do if the market fell 20%" ... "Why, I'd patiently buy more, thanks for asking!". Yet market bottoms seem to produce capitulation from even the most stalwart bulls. The only way to truly know is to experience the feeling of having your "best" stock take a 20% haircut, and then watch all the analysts who you relied on when you bought it move to HOLD...or in some of the most dramatic cases, maybe even SELL.

This is the one thing that can make an experienced amateur investor better than all the young MBA/CFA-types who think that everything fits into a spreadsheet.

[yielder]

While risk tolerance questionnaires do have their place, the piece that they can't account for is the emotional factor. People know the "right answer" to a question like: "What would you do if the market fell 20%" ... "Why, I'd patiently buy more, thanks for asking!". Yet market bottoms seem to produce capitulation from even the most stalwart bulls. The only way to truly know is to experience the feeling of having your "best" stock take a 20% haircut, and then watch all the analysts who you relied on when you bought it move to HOLD...or in some of the most dramatic cases, maybe even SELL.

This is the one thing that can make an experienced amateur investor better than all the young MBA/CFA-types who think that everything fits into a spreadsheet.

Yep, the questionnaires aren't a panacea but they seem to be pretty well designed to handle peoples' inconsistencies, incompetences, and irrationalities. For example, playing with this one by selecting all of the high risk answers and choosing an age under 30 and a number of years until retirement greater than 20, produces a score of 259 which is just below the 260 max for this Aggressive with high risk tolerance category and a recommended asset mix:



Keeping the answers the same but choosing an age over 70 and retired, the score drops down to 227 which is at the high end of the immediate lower category, Balanced with above average risk tolerance:



Even with the more conservative response, it's quite possible to load the equity component with precious metals & oil because they are hot, hot, hot and then have to deal with a meltdown. What people don't realize about these questionnaires is that they are aimed at risk definition and reduction. I've always believed that if you focus on the risk, the returns will take care of themselves.

[Big Bob]

While risk tolerance questionnaires do have their place, the piece that they can't account for is the emotional factor. People know the "right answer" to a question like: "What would you do if the market fell 20%" ... "Why, I'd patiently buy more, thanks for asking!". Yet market bottoms seem to produce capitulation from even the most stalwart bulls. The only way to truly know is to experience the feeling of having your "best" stock take a 20% haircut, and then watch all the analysts who you relied on when you bought it move to HOLD...or in some of the most dramatic cases, maybe even SELL.

This is the one thing that can make an experienced amateur investor better than all the young MBA/CFA-types who think that everything fits into a spreadsheet.

Absolutely right, I'm afraid to say. When the market is going up everyone is a gunslinger. In the days of irrational exuberance I was fielding calls from people enraged that they were "falling behind" and telling us that they could not afford to stay in the balanced portfolios they had.

The question becomes: do you give people the advice that is good for them or do you give them what they want?