By Daniel Archibald | CFA
If you have seen a financial adviser in the past decade or so, you would have undoubtedly had the pleasure of completing a risk profile questionnaire. The purpose of such a tool is to try and illustrate and approximate a client's attitude towards the risk that is inherent in investments. That is, to help the client and adviser understand how risky their investment portfolio should be. The risk profile is then translated into an asset allocation, diversified across the major asset classes (shares, property, bonds, cash, alternatives).
Despite the large body of knowledge on the matter, there are a few issues in risk profiling and asset allocating, which, if not considered appropriately, can potentially lead to poor portfolio construction outcomes.
What is investment risk?
Risk means different things to different people. Thus, a standardised questionnaire is likely to cover many, but not all, attributes that might qualify as risk considerations. To some, risk only relates to the potential for loss. For others, risk relates more to not achieving the level of return needed to meet some future expense. And for others, risk is purely a function of the level of discomfort that comes from not knowing what tomorrow may bring.
Lumpy assets
Many investors will hold (or look to hold) assets that, by their nature, are likely to take up a big portion of their asset base. The biggest culprit in this regards is property. Many investors who hold an investment property may see this particular asset taking up much more than half of their total investments. However, most diversified asset allocations will put property or alternative assets at below 20%. Lumpy assets will thus demand a rethink to how the portfolio is constructed and will likely require other asset classes to be reduced significantly.
Quasi-investments
Which assets are investments and which are non-investment (or personal)? Generally-speaking, assets which yield a realisable return would be considered to be investments, whereas assets which are mainly to be used for consumption purposes (housing, cars, etc) are not considered to be investments. But what about a home with a granny flat, or a car that is also a collectable. It is important for investors to understand what assets (or part thereof) are owned for investment purposes and to include such in overall portfolio construction.
Human capital
You may have heard that the most important asset you own is you (or your capacity to earn income). Including your expected earnings from employment, and the associated risks to those earnings (injury, redundancy, death, etc) can help an investor build a more diversified wealth portfolio. An application of human capital into the asset allocation question might be investing in assets whose returns are uncorrelated with your employment industry. For example, a mining engineer would invest in industrials and avoid mining stocks. The theory behind this being that if the mining industry goes into contraction, the loss that might come through a potential loss of job would be offset by not losing wealth in mining shares.
Understanding where you sit on the investment risk spectrum is an integral part of the portfolio construction process. Furthermore, proper consideration of the make-up of your financial capital (investments and personal assets) along with the characteristics of your human capital (wage growth, industry, etc) can help provide a more holistic portfolio outcome.