Are there dangers lurking in the risk profiling process?

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Articles by Tom

Tom Saville

Investment Manager

2 October 2019

Whilst risk questionnaires can give insight into a client’s willingness and ability to bear risk, we do not believe they give the full picture, especially when we then try to connect them to an investment solution.

As an investment manager preoccupied with keeping their clients safe, we wanted to outline where we see the dangers lurking in two key assumptions which underlie most risk models.

First assumption

Historic price volatility is a complete measure of an asset’s risk

This is a concept that we fundamentally disagree with. Why?

Take turkey farmers for example. A turkey is born and enjoys an extended period of very low volatility growth. From a narrow perspective as it fattens, the turkey looks increasingly like a winning bet. However if you widen the perspective it may not be so lucrative; the growing threat of Christmas is looming. The Turkey’s low volatility growth belies an obvious risk, a principle we often observe in financial markets too.

The charts below demonstrate this, showing the live weight of the turkey and the performance of a fund dedicated to shorting the VIX volatility index that fell sharply overnight in February 2018 when the volatility index spiked. In both cases a rare but predictable event arrives bringing extreme volatility.

Our concern is that the asset management industry’s over reliance on volatility as a measure of risk is driving some dangerous distortions, including chunky allocations to increasingly overvalued low volatility assets such as corporate bonds, defensive equities and structured products.

To make matters worse this error is frequently compounded by the belief that by packing a portfolio full of different low volatility components we can manufacture a product that suits a low risk client; in essence the more turkeys the better. This theory can only work if we assume that the individual components of the portfolio are not all vulnerable to the same thing. Which is why the second key assumption becomes important.

Risk profiling chart

Second assumption

The price of stocks and bonds move in opposite directions, and will do so forever.

Thinking about this from a short term perspective the above assumption would be correct but look from a longer-term perspective and the story is very different.

Stock bond negative correlation is the keystone of modern portfolio construction. However for the majority of the last 200 years (the period in the chart above) the correlation between stocks and bonds is actually positive. It is also dependant on inflation. When inflation is low and controlled the correlation between stocks and bonds remains negative but during more inflationary regimes this correlation reverses with both equities and conventional bonds falling in concert. Like any behaviour, the reliance on bonds for diversification has evolved because it has worked over most investors’ life-times. Very few of us have had to manage money during a period of above trend inflation and as a consequence a reliance on negative stock bond correlation has become conventional wisdom in this period of stability. This mentality has meant investors’ portfolios are becoming increasingly vulnerable to the same risk factor.

Another way to look at this is through the lens of nature and specifically the Great White Shark. Any species which evolves during a period of stability becomes increasingly sensitive to a change in their environment. Over millions of years the Great White Shark has evolved a specific set of tools that establishes it as the most terrifying predator of the marine world. However even subtle changes in the ocean temperature can have profoundly negative effects on its population numbers. We think markets are in a similar position; the slow downward grind in long-term bond yields means that asset prices are more sensitive to inflation than ever, and even a whisper of its return will make the traditional balanced portfolios look like a shark out of water.

So what should be done?

It would not make sense to abandon risk profiling altogether; the process is a useful exercise to learn about clients’ preferences. But we do think advisers should put their investment managers under greater scrutiny when they promise a plug and play solution. Additional qualitative processes, built around an outcomes based framework, may help reveal the risks that investment managers are building into your clients’ portfolios.

How sensitive is the portfolio to a rise in interest rates? What would be a nightmare scenario for the portfolio? How might the portfolio behave were inflation expectations to increase?

Questions like these help to add a vital qualitative element to the assessment of a portfolio’s risk; an important complement to the quantitative, backward looking approach that will often miss the effect of those rare, but predictable events.

Find out more about how we think: read our monthly publication The Green Line.

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Are there dangers lurking in the risk profiling process?