Risk is not the volatility of your investment portfolio, or volatility of returns, risk is determined by your investment goals.
This is the view of Nobel laureate Professor Robert Merton. Such an assessment of risk also underpins many Goals-Based wealth management solutions.
More robust investment solutions are developed when the focus on risk moves beyond variations of returns and volatility of capital. The key risk is failure to meet your investment objectives.
The finance industry, many financial advisors and academics express risk as the variation in returns and capital, as measured by the standard deviation of returns, or variance.
Nevertheless, clients often see risk as the likelihood of not attaining their investment goals.
The traditional financial planning approach is to understand client’s goals, then ask questions to determine risk tolerance, which then leads to advising a client to adopt a portfolio that has a mean expected return and standard deviation corresponding to the Client’s risk appetite. Standard deviation of returns, variation in capital, becomes the measure of risk.
Nevertheless, a different discussion with clients on their goals will likely result in a different investment solution. It will also improve the relationship between the Client and the Advisor.
Such a discussion will lead to more individualised advice and a better understanding of the choices being made. Clients will be in a better place to understand the impacts of their choices and the probability of achieving their goals. It will be more explicit to them in making trade-offs between playing it safe and taking risks to achieve their investment goals.
A goals based approach provides a more intuitive, transparent, and understandable planning approach.
Ultimately it leads to a more robust portfolio for the Client where information from the goals-based discussion can be mapped to a specific range of portfolios.
It is also a dynamic process, where portfolios can be updated and changed on new discussions and information. The process can adapt for multiple-goals over multiple time periods.
This is in stark contrast to the single period single objective, static portfolio traditionally implemented based on risk appetite.
There is also a strong foundation in Behaviour Economics supporting the Goals-Based investment approach.
I have covered Merton’s view in previous Posts, so please don’t accuse me of confirmation bias!
Merton’s views on risk is also well presented in a 2016 i3 Invest article in Australia, Risk is determined by Investment goal.
“Risk is not simply expressed as the volatility of your invested assets, but is determined by your ultimate goal, according to Nobel laureate Robert Merton.”
The i3 article provides an example on how your goal determines to a large degree what your risk-free asset is.
The goal provides a starting point for determining:
- how far removed you are from achieving your objectives; and
- importantly, how much risk you need to take to have a chance of meeting these objectives.
“If you had as your goal to pay your (Australian dollar) tax bill in a year from now, then what is the safe asset for you?”
“It would be an Australian dollar, one year, zero coupon, Australian Treasury Bill that matures in one year. That would be the sure thing.”
As the i3 article mentions Merton has criticised the idea that superannuation is a pot of money, instead of a basis for generating an income stream.
Merton argues that there should be greater focus on generating replacement income in retirement and we need to stop looking at account balances and variations in account balances. Instead, we should focus on the income that can potentially be generated in retirement from the investment portfolio, pot of money.
This is not a radical idea, this is looking at the system in the same way as Defined Benefit Funds did, the “old” style funds before the now “modern” defined contributions fund (where the individual takes on all the investment risk). Defined contributions funds focus on the size of the pot. The size of the superannuation pot (Kiwisaver account balance) does not necessarily tell you the standard of living that can be supported in retirement. This is Merton’s critical point.
A greater focus on income is aligned with goals-based investment approach.
As Merton’s explains, if we accept we should focus on income, targeting sufficient replacement income in retirement, the development of a comprehensive income product in retirement is not difficult. He concludes, “This doesn’t require the smartest scientist in Australia to solve this problem. We know how to do it, we just need to go out and do it,”.
As noted above I have previously Posted on Merton’s retirement income views. The material from these Posts comes from a Podcast between Steve Chen, of NewRetirement, and Professor Merton. The Podcast is 90 minutes in length and full of great conversation about retirement income. Well worth listening to.
For those wanting a greater understanding of Merton’s views and rationale please see:
- What matters for retirement is income not the value of Accumulated Wealth
- Is variability of retirement income a better measure of risk rather than variability of capital? – What matters for retirement is income not the value of Accumulated Wealth
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