"HatTip" - What's Your Attitude to Pain?!

The inspiration for this piece comes from US based adviser Alan Roth. In a recent blog he pretty much summed up everything that is wrong with my profession's fixation on investor "attitude to risk".

Here is the process: you plod through a questionnaire given to you by your adviser; the adviser feeds the answers into a bit of software; hey presto, you are told that your attitude to risk is 8 out of 10, or “balanced”, or “low-risk” or some other meaningless grading.

It is meaningless because a risk score simply pretends to know demonstrates how much pain someone can bear to take when markets fall.

But just because you theoretically can mentally stomach a large loss in your portfolio does not mean you have to. This is because - on its own -the risk attitude questionnaire bears no relation to the actual return that a client needs to get to achieve her life goals.

For example, if your portfolio simply needs to “earn” 3% a year to maintain your lifestyle then why on earth would you be in a portfolio that carries the potential return and commensurate risk of, say,  8% a year?

A risk questionnaire, as seen yesterday

Advisers that answer with "my client's attitude to risk score indicated that was the ideal portfolio" are just doing half a job.

Even worse, imagine a “cautious” risk profile client, advised to invest in a portfolio that will ensure he runs out of money before he runs out of life. What is the biggest risk for all of us? A temporary dip in the value of our investments (because markets go down as well as up) or a permanent drop in lifestyle when we run out of money?

Risk assessment questionnaires and their ilk are only ever the starting point of a conversation about your investments. Far more important is the return you need to get on your assets so as not to run out of money during your lifetime. When you know this figure then you can construct a portfolio that has the best chance of achieving it (in no way guaranteed etc).

If the resulting portfolio is too racy (or too cautious) for you, then adjust accordingly and accept the consequences on your lifestyle. But remember: markets generally recover from falls; time is a great healer. However if you run out of money in later life then all the time in the world will not save you: the dosh is gone and it ain't coming back. That is real pain.

A short term paper loss or a long-term drop in living standards? The choice is yours!