Ever wonder why we chose six months for the portfolio's probability range time-frame? There's a lot of power in a six-month sound bite.
As you may know, Riskalyze empowers advisors to quantitatively determine a client’s risk tolerance, and build a portfolio to fit.
At the end of the risk questionnaire, we turn the client’s multi-dimensional Risk Fingerprint into a comfort zone … a certain amount of downside risk the client is comfortable taking over a six-month time-frame, in exchange for the opportunity to achieve a certain amount of return.
Every time an advisor builds a portfolio, Riskalyze calculates a six-month Value at Risk.
For example, our Risk Number® and corresponding six-month 95% Probability Range is a historical calculation using a variety of statistical inputs, based on the price history (expense ratios, dividends, etc.) at the holding level. This last statement bears repeating; we do not use the antique process of mapping holdings to a set of assumptions at an asset allocation level. Price, at the holding level, is truth. We derive our statistics from each holding's actual price history because it's more robust than an asset allocation mapping methodology.
Even though our six-month 95% VaR is a historical calculation that does not explicitly say "here's what is predicted to happen in the next six months," we assume that humans may implicitly apply historical probabilities into the future.
While we can all recite the phrase "Past Performance Is No Guarantee of Future Results," for a reason, we test our methodologies to inform best practices for those who implicitly use the past as an input for what to expect in the future.
Develop Long Term Thinking
Some advisors have questioned our decision to use a six-month timeframe for this process. They worry that any discussion about a six month period will lead investors to invest on a short term basis.
We believe the opposite is true, and here is some data you can share with your clients to demonstrate why your approach as a Risk Aware Advisor is the correct one.
We’ve found that six months is a very effective period of time for assessing the risk of a portfolio and comparing it to a client’s risk tolerance. It’s a period of time that clients have easily related to in our research. And it also happens to be a time period that allows us to build a much tighter probability range using standard deviation.
To keep clients focused on the long term, we recommend against discussing a portfolio’s expected return, whether for six months or a year. We only need to look at the broader stock market to understand why.
Over the 25 years from 1988 to 2012, the stock market rose an average of 9.7% annually. But in all twenty-five of those years, guess how many of them came within 100 basis points of that 9.7% average? Only one – 2004 with a 9% gain.
So while the markets average out to a nice number, they very rarely hit that average in any given year. The same will be true for a portfolio, so setting client expectations with expected average returns really sets an advisor up to fail.
That’s why Risk Aware Advisors are shifting the focus of their client discussions to investing within a probability range, rather than investing for a particular targeted return. It increases the likelihood of success and keeps clients focused on what is really important – staying invested for the long term.