The term “risk” has different connotations, depending on the client’s frame of reference, circumstances, and objectives. Typically, the investment industry defines risk in terms of statistical measures, such as standard deviation. However, these statistical measures may fail to adequately communicate the potential negative consequences an investment strategy can have on the client’s ability to meet objectives; particularly those covering short-term liability requirements.

For Behavioral Governance, risk is defined as the probability or likelihood that the client will not achieve their goals and objectives (Dimension 1.2). Applying such a definition means that cash could be “riskier” than equities if the investment strategy has not been structured to offset the effects of inflation; or the client abandons their strategy at precisely the wrong time and for the wrong reason because of unwelcome volatility.

For this reason, the most effective way to determine the client’s level of risk is to ask: “How much money are you willing to lose in a given year?” The response to that question often is more revealing than any information that can be gleaned from portfolio modeling and optimization software.

It’s a good idea to discuss with a client whether any of the following factors may be relevant:

  • Liquidity risk – the inability to have cash when obligations come due.
  • Asset allocation risk – the asset mix associated with the client’s existing investment strategy has a low probability of meeting the client’s goals and objectives.
  • Boardroom risk – the investment committee may not have the stomach to ride out short-term volatility in favor of a more appropriate long-term investment strategy.
  • Purchasing power risk – the adoption of an investment strategy that will not keep pace with inflation.
  • Lost opportunity risk – the right investment strategy is developed, but not implemented: “Yes, I know I should have a larger allocation in equities, but now is not a good time to buy.”
  • Funding risk – a sponsoring organization can no longer make contributions. (For example, the plan sponsor of a retirement plan.)

As a fiduciary, your role is to decide which asset classes, optimally allocated, will produce the greatest probability of achieving the client’s stated objectives (Dimension 1.2).

As with “risk,” an asset class discussion can have different connotations, depending on the client’s frame of reference and preferences. For example, a client could have misplaced confidence/comfort in a fixed-income strategy simply because it is labeled as a “bond portfolio”—think subprime meltdown.

The process begins with a thoughtful discussion with the client focusing on the relative attractiveness of the broad asset classes, ensuring that the client has a good understanding of the risk/return profile of each. Once a decision is made regarding the allocations of equities, fixed income, and cash (the primary determinants to the risk/return profile of the client’s overall portfolio), consideration should be given to diversifying the portfolio further into a broad global mix.

A key question that typically emerges at this stage is: What is the appropriate number of asset classes for the client’s investment strategy? The answer—it depends on the facts and circumstances:

  • Your expertise: Stick with what you know best, and stay clear of any asset classes or strategies where you lack the time, inclination, and knowledge to properly conduct your due diligence, or to monitor.
  • Your client’s expertise: No great insight here—the investment savvy-client will likely be more willing to accept a more sophisticated investment approach. The less sophisticated client might accept your initial suggestions, but will likely bolt during periods of market volatility.
  • Sensitivity to fees: You have a responsibility to control and account for all of the expenses associated with a client’s investment strategy (Dimension 4.2). More asset classes will mean higher expenses. Does the addition of more asset classes justify the additional expense
  • The size of your staff, and whether you are taking full advantage of technology: If you have made a decision not to complicate your life with additional staff or technology, than you should keep your investment strategies just as uncomplicated.
  • Potential liability: Diversification is intended to reduce risk. However, diversification into esoteric strategies or asset classes may increase liability.

One of the critical roles you play as the investment advisor is to help ensure that the client has sufficient liquidity to meet financial obligations when they come due. As a best practice, we would suggest that you prepare a cash flow statement for each client that shows anticipated contributions and disbursements for, at least, five years out.

Such a cash flow analysis is essential in determining the client’s investment time horizon: That point in the future when more money is flowing out of the portfolio than coming in from contributions and portfolio growth.

The identification of the client’s investment time horizon often is the key variable in determining the allocation between equity and fixed income. As a general rule of thumb, time horizons of less than five years should be implemented with cash and fixed income; while time horizons of greater than five years should be allocated across a broad range of asset classes. Even if an investor has a very high risk tolerance, the investor should not invest in equities if the money is required in the next year.

Expected outcomes differ from the long-term goals and objectives identified in Dimension 1.2, in that they represent quantifiable results expected to be achieved over a shorter, specified time horizon. For example, an expected outcome may be to produce a total rate of return that exceeds the rate of inflation by a certain amount.

Another mistake individuals tend to make is to confuse their date of retirement with their investment time horizon. The start of retirement plan distributions does not determine the time horizon unless the investor is withdrawing more money than the portfolio is able to replace through investment growth. Under normal circumstances, when an individual has sufficient assets to retire, the time horizon will be the time over which one will consume retirement income.

The identification of expected outcomes serves three purposes:

  1. They are necessary inputs to the investment strategy inputs (Dimension 3.1);
  2. They are important components to communicating a client’s investment strategy (Dimension 3.2); and
  3. They facilitate the establishment of benchmarks for the monitoring phase (Dimension 5.1).

Neither regulators nor courts expect you to be able to forecast future returns or events, but they do expect you to be able to demonstrate that the client’s investment strategy was based on thoughtful and realistic performance expectations.