Goal tolerance: When goals meet risk tolerance

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By Wade Matterson, Craig McCulloch | 01 March 2017

There are clear reasons why risk tolerance drives the financial advice process.

It produces a simple number, which makes it relatively easy to recommend investment products while maintaining a compliant paper trail. But such a heavy reliance on risk tolerance can also produce significant problems.

Risk tolerance is too often thought of as an unchangeable number even though there is little academic guidance on the most effective way to measure it, leading to widely varying estimates (and subsequently portfolios) between advisers.

As the Financial Ombudsman Service noted back in 2011, risk tolerance is just one tool that can show a client understands the level of risk required to achieve objectives.

Placing a greater emphasis on clients’ objectives and wrapping this around their risk tolerance can produce higher levels of engagement and offers a more accurate pointer to investor behaviour.

Bringing goals to the fore

Many first generation risk tolerance questionnaires posed “thought bubbles” only loosely tied to a client’s actual circumstances. This led to a recommendation to invest in an “appropriate” portfolio but, not surprisingly, rarely predicted the real-world behaviour of clients, particularly during periods of poor market performance.

Clients can’t accurately rank the impact of a potential loss (whether $1000 or $100,000) outside of their personal circumstances–and in many cases, weren’t asked to. However, as a new generation of risk profile tools has emerged, an increasing focus on understanding an individual’s appetite to absorb these types of losses has helped to create a deeper understanding of investors and their sensitivity to volatile investment returns.

However, there is still a significant difference between an abstract investment experiment and linking the outcomes of these experiments to the goals of clients. Further, while investment returns are an important source of variability, they are only one factor that influences the ability to meet financial goals. Inflation, interest rates, health and client behaviour all have roles to play.

We believe that the next generation of tools, advice platforms and planning strategies will be driven through a deep understanding of each investor’s “goal tolerance”.

Goal tolerance, as the name suggests, is the process of establishing a client’s appetite for variation to specific financial goals which can then be used to establish an appropriate portfolio. It also offers a potential framework for monitoring and managing that client’s position over time as circumstances change.

Consider retirement income for example. As highlighted below, retirement income is itself a combination of multiple goals.

Secondly, each of the individual goals that make up a retirement income objective will have its own priority and, in turn, the risk of failing to meet the objective that an investor is willing to accept.

1. Basic income needed for security and subsistence

This is the level of income a client needs to pay for basic needs including food, warmth, shelter and general security. Most people will have little tolerance for variations in this income. However, at this level, Social Security such as the Age Pension plays a key role–this knowledge can provide a greater level of certainty to many clients (although risk remains as regulatory rather than market-based).

2. Lifestyle goals above basic subsistence

This is the level of income needed to fund more discretionary pleasures and psychological needs that generate self-worth. These can include holidays, going to restaurants, education, moving to a larger home and so on. There will be more tolerance for failure at this segment of income goals. For example, some people will be just as happy to have a lower-cost domestic family holiday rather than an overseas trip.

3. Self-actualising goals

This level describes the highest-level lifestyle goals or dreams of clients. High-net worth investors with significant levels of discretionary income and assets are likely to have greater levels of tolerance to variations in the income needed to fund these activities.

Finally, the tolerance for variability with respect to personal goals changes over time as investor priorities shift, goals are achieved and discarded or circumstances change.

For example, a client may have a key lifestyle goal to play golf three times a week in retirement. But if his/her health declines to the degree he/she is unable to play, this goal needs to be culled or replaced with a new one.

Their previous tolerance to producing income to achieve this goal will now differ, given those funds will be directed towards a new goal which may have become more important.

This highlights the active role required by advisers to assist their clients in the articulation, implementation and management of a goals-based approach. Goal tolerance and segmentation of portfolios to help achieve these goals can create a more personalised and compliant solution whilst at the same time producing better outcomes.

The science of measuring risk tolerance–and in particular goal tolerance–is still in its infancy and evolving rapidly. However, measuring it shouldn’t be a set-and-forget exercise as some suggest. It clearly changes over time depending on several factors including age, financial capacity, affluence and goals.

This goals-led advice approach takes risk tolerance out of the abstract realm, providing the basis of a real relationship between adviser and client through engagement and meeting the client’s true needs.

Disclaimer

This document has been prepared by Milliman Pty Ltd ABN 51 093 828 418 AFSL 340679 (Milliman AU) for provision to Australian financial services (AFS) licensees and their representatives, [and for other persons who are wholesale clients under section 761G of the Corporations Act].

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