Tailoring funds to risk profiles

Modern portfolio theory relies on several crucial assumptions. Among them is the perception of a rational investor. While this assumption may be realistic for institutional investors, it can be very problematic for private investors. A rational investor is risk averse in the sense of preferring lower volatility investments to investments with a higher spread of returns but the same expected value. Volatility is a symmetric concept which means that positive and negative deviations from the mean increase the risk measure to the same extent. Private investors, on the other hand, usually have an asymmetric utility function. The increase in happiness (or marginal utility) caused by a gain of a certain amount is smaller than the decrease in happiness caused by a loss of the same amount. In this sense, private investors can be called loss averse rather than risk averse. During the phase of booming capital markets in the 1980s and 1990s, this concept tended to be neglected. However, after the experiences of 2000-2002, many private investors, as well as their financial advisers, have been painfully reminded of it. The response was a resurgence of absolute return concepts.

Consistency

Many mutual fund companies have followed this trend and have offered products accordingly. In addition to products like mutual funds, Deutsche Bank also offers customised strategies in discretionary portfolio management for private clients.

For example, Deutsche Bank’s Absolute Return model aims at smoothening returns and achieving consistent capital growth rather than accepting high interim risks in the hope of achieving long-term returns. Downside risk is systematically limited by investing a certain share of the assets in stable investments with minimum risk and supplementing it with some riskier but little correlated assets to improve returns. The portfolios are very conservatively managed using risk accounts comprising the sum of downside risks of all included assets. The beneficial effects of low correlation among the assets in the portfolio are deliberately ignored to achieve a risk buffer and brace oneself for critical situations in capital markets when correlations between different assets tend to increase. Another solution offered to Private Wealth Management clients is a volatility-based management approach which works with financial derivatives in order to take advantage of trends in volatility. In rising markets that are usually accompanied by low volatility, portfolio insurance is acquired so that losses are limited when markets fall. Conversely, in times of falling markets when volatility increases, additional returns can be achieved by collecting option premia. The specific strategy for each portfolio is determined by the client’s individual risk profile.

In order to determine a client’s risk profile, both the client’s ability and willingness to take risk must be evaluated. The client’s ability to take risk is mainly determined by objective factors. One of the most important ones is the time horizon associated with the investment. The longer the time horizon, the more risk can be taken in the investment since the probability of recouping any losses is larger if more time is available until the funds are needed.

Risk tolerance

Other factors include the client’s liquidity requirement (if the client relies on withdrawing funds from the investments, especially if the timing is not predictable well in advance, a sufficient share has to be invested in low-risk, highly liquid assets), the client’s financial strength (such as how large the spending requirements are relative to the client’s total wealth) and the long-term wealth targets and obligations.

The client’s willingness to assume risk, on the other hand, is a more subjective concept and requires a large degree of psychological awareness on the part of the adviser, in addition to sophisticated analysis tools. Factors that have to be considered here include: sources of wealth (for example, clients who created their wealth by entrepreneurship often have a better ability to deal with risk than clients who inherited their wealth), measures of wealth (the larger the wealth in the perception of the client, the higher the risk tolerance tends to be), and stage of life (risk tolerance usually falls with higher age).

At Deutsche Bank Private Wealth Management, advisers are supported by a highly specialised and state-of-the-art quantitative analysis tool in determining the client’s risk profile and matching it with an adequate portfolio structure. The analysis is based on a structured questionnaire developed in cooperation with renowned scientists. It enables the adviser to assess even the client’s more concealed and possibly sub-conscious attitudes and also takes into account aspects of behavioural finance. For example, clients are presented with different scenarios and asked to choose the response most applicable to their likely personal reaction. The subjective risk tolerance investigated in this way is then combined with the parameters determining the client’s ability to take risk as well as his financial goals in order to establish the overall risk-return profile.

In the process of devising a wealth structure adequate for this risk-return profile, there is an entire range of analytical and scenario simulation possibilities available to the adviser.

The client’s portfolio structure can be displayed according to criteria such as region, risk factors, volatility or currency and the effects of different scenarios assessed. Also, an individual portfolio can be constructed using multi-period optimisation and matched with the client’s risk-return profile.

Scenarios

The use of a quantitative analysis tool can of course never substitute for the highly personal relation�ship between client and adviser, which forms the base for professional wealth counselling. However, it is a valuable support and helps to ensure that all asset allocation and product recommendations match the client’s individual situation and personal goals at all times.

Anja Raffelsberger, CFA, Global Strategic Development Portfolio Management, Deutsche Bank Private Wealth Management