The potentially perverse nature of risk budgeting
Risk budgeting can be a relatively straightforward exercise and, if highly personalised, is an essential step in the execution of a successful wealth plan. At MASECO we budget for risk by thinking both about the ability to take risk, which tends to be governed by the investment horizon, and the willingness or tolerance to take risk, which tends to be more individual. An example can help illustrate this concept. An individual may have a low tolerance for risk, which can be evaluated by how easily they sleep at night during times of market volatility, but at the same time may have a relatively high ability to take risk, if for example investing to meet their retirement needs in 25 years’ time. There is no exact science to this, but assuming that the goal is to maximise returns over the 25 year investment horizon, the greater the risk they can tolerate the greater the expected returns over the period, and the more successful the outcome is likely to be. However, if they take on too much risk compared to their risk tolerance, they may find themselves falling into the behavioural finance biases of divesting from the portfolio when the markets are down. This most likely leads to missing out on the ensuing recovery, thereby significantly reducing the return over the 25 year cycle. It is up to the skill of the adviser to recommend a risk budget that can fulfil both criteria.
However, at MASECO we are coming into increasing contact with individuals who have accumulated surplus wealth compared to their requirements. In other words, individuals who have wealth that they are unlikely to spend in their own lifetimes and will likely pass down to the next generation. In this instance the philosophy behind risk can become somewhat perverse. Arguably individuals in this circumstance have a limitless ability to take risk, yet have no need to take on risk to meet their goals. So, should they be shooting for high returns, with no regard for the volatility, given they have no particular need for the capital? Or, conversely, should they be sticking the capital under the mattress to avoid even a whiff of volatility, as they have no need to make a real return and thus they may be able to sleep easier? As is always the case, the solution tends to be somewhere in the middle. The truth is that there is always a goal for the capital, even when that capital is surplus to immediate requirements. Sometimes that goal is legacy, and other times it might be philanthropic or impact investing. In this case it is up to the skill of the adviser to better understand the wider goals of the individual or family involved, and adjust the risk accordingly. From our perspective, once the risk budgeting has been agreed, the next part of our job is to access the capital markets as efficiently and inexpensively as possible. That is, to ensure risk-adjusted returns are maximised, or to put it more technically that we are investing on Harry Markowitz’s efficient frontier.