Rethink your asset allocation based on your life goals

Whenever we talk about investments, one question needs answering – what is your risk profile? Your bank is legally obliged to establish your investor profile before providing advice, but it is also essential that you properly understand what is meant by risk-taking.

Since the sub-prime financial crisis, it has been compulsory to answer a questionnaire to define your risk profile or investor profile before investing. This is focused around four complementary pillars: your knowledge of investing, experience, risk appetite and ability to bear losses. The aim of these regulations is to help investors avoid major losses due to a lack of awareness of the risks involved in investing in financial instruments.

Readers of our myINVEST series are well aware that there are no guarantees when it comes to investing. Past performance is not an indication of future results. Investing always involves risk and readers are familiar with the terms used to determine a scale for the propensity to take risk – conservative, cautious, balanced, dynamic. Undoubtedly, they are less familiar with the idea that when investing, risk is not simply an objective concept linked to the way that we position ourselves versus sometimes unpredictable market fluctuations. The concept of risk is also subjective and must be established in connection with the deep aspirations and life trajectory of the investor. From this perspective, the greatest risk is investing in instruments that do not suit you and do not enable you to achieve your life goals.

The concept of risk is also subjective and must be established in connection with your deep aspirations and your life trajectory.

Understanding risk

When we talk of risk, what exactly are we talking about and what are the real challenges? There are numerous types of risk when investing (exchange risk, interest rate risk, default risk, market risk, inflationary risk, etc.) and many methods for calculating the risk of a portfolio (standard deviation, Value at Risk, sensitivity analysis, specific risk measures, etc.). In simple terms, we generally consider the risk taken as the exposure, volatility and potential fluctuations of your investment portfolio versus market movements.

From a technical standpoint, defining your risk profile or investor profile must enable your banker to identify, on the basis of your current situation, the asset classes and investment vehicles that are the most appropriate for achieving the goals that have been set for a determined time horizon. Based on traditional portfolio management theory as defined by US economist Harry Markowitz, portfolios are a group of financial instruments which must be combined such that their risk/return characteristics provide the return sought by the investor.

Put like this, it is a purely rational and mathematical matter. Sadly, markets are often far from rational and their movements are often unpredictable. What’s more, the reaction of investors in response to these upheavals are sometimes irrational. And this places any models for calculating risk under severe strain. So what should you do?

In real life, investors are subject to restrictions and do not act based on the rationality model used in traditional financial theory. A useful starting point is to distinguish between the ability to take risks and the aversion to risk. The ability to takes risks depends on objective economic circumstances, liquidity requirements, income, assets, taxes, etc. This is relatively insensitive to psychological distortion or subjective perception. For its part, risk aversion can be understood as the combination of psychological traits and emotional responses which determine the degree of psychological or emotional pain that investors feel when confronted with financial loss.

Life goals rather than abstract figures

Whilst models can be useful, it is important to consider what risk-taking represents at a personal level. For the most conservative profiles, this corresponds to any investment likely to result in a loss. For the most dynamic profiles, it corresponds to the loss that one is prepared to accept in the event of an unfavourable scenario, in order to take advantage of a potentially very profitable opportunity. This means that seeking an absolute position relative to the market is a source of uncertainty and worry for some, and of dangerous excitement for others.

Using the market as the sole criteria for a decision will simply fuel your cognitive biases, your emotional responses or your desire to compare yourself with others. This is not meaningful with regard to your life goals.

This is where extreme vigilance is required. Using the market as the sole criteria for a decision is not really meaningful with regard to your life ambitions. Worse still, it fuels your cognitive biases, your emotional responses or your desire to compare yourself with others. This is particularly the case if you are at the extremes of the risk appetite scale.

The true purpose of an investment portfolio is not to help you outperform your neighbour, but to help you meet your objectives and enable you to achieve your life goals. Seen in this way, your risk profile should define your propensity to take risks in order to achieve your personal objectives, and not your ability to take risks to beat the market.

This is the approach recommended by behavioural portfolio theory which – in contrast to traditional portfolio theory – does not consider portfolios as a simple collection of financial instruments. Based on this approach, portfolios are primarily considered as a means to an end. They have no legitimacy other than to the extent that they enable investors to achieve certain real-life goals (retirement, the education of their children, marriage, second home, etc.).

In a behavioural portfolio, risk is not defined as a variance versus the average, but rather as the inability to achieve a predefined goal.

In a behavioural portfolio, risk is not defined as a variance versus the average, but rather as the inability to achieve a predefined goal.

Define your pyramid of needs

What is the advantage of this approach? It takes account of the fact that successful investing is difficult on the emotional front. The work of behavioural economists Daniel Kahneman and Amos Tversky has shown that people often take decisions based on mental shortcuts rather than on pure logic. These shortcuts may lead to sub-optimal decision-taking and cause us to act counter to our own interests. We overreact to short-term market movements and lose sight of our long-term objectives. We may also be tempted by herd behaviour, blindly following others on markets rather than thinking about our own interests.

Behavioural portfolio theory takes potential errors of judgement by investors into account and invites them to maintain some distance from abstract market numbers and to take measures to secure their concrete personal life goals.

Based on the theory proposed by Shefrin and Statman in 2000, a behavioural portfolio should resemble a pyramid with distinct layers. The base layer is designed to act as a safety cushion to avoid a financial disaster, whilst the top layer is designed to try and maximise returns in order to potentially grow your assets. Instead of proposing an abstract curve with different combinations of the risk/return variable, behavioural portfolio theory allows us to think of asset allocation in a way that is very close to the human way of thinking. It provides a more precise representation of the way that decisions are really taken by allowing each individual to easily create a pyramid that prioritises their aspirations and enables them to allocate the corresponding assets to each of these.

For example, the fundamental base layer is the bedrock which allows you to avoid financial ruin and ensure the transfer of your estate to your children; it uses financial instruments which may not deliver exceptional returns but which ensure the sustainability of your estate. This typically means savings products.

The next layer may, for example, be devoted to creating a reserve to ensure that you can finance projects in the future, such as your children’s education. Next come the layers aimed at financing those “little extras” such as the purchase of a second home or investments for pleasure, e.g. in art or wine. Lastly, you can afford to invest in assets that you are passionate about and which correspond to causes that are dear to you such as medical research.

Thinking about asset allocation on a behavioural basis allows you to dispense with a certain number of cognitive biases and to define limits.

Thinking about asset allocation on a behavioural basis allows you to guard against a certain number of cognitive biases and to define limits based on the layer of the pyramid that you are seeking to build. You will no longer think on the basis of the market, but on the basis of achieving your objectives.

When asked to define your risk profile, you should always consider this within the context of achieving your objectives and aspirations. Your banker will help you with this exercise before discussing the exact composition of your portfolio. Whilst they can help you to execute your investment plan, you alone can define your life goals. Come prepared!

Investment is a mix of logic and emotion. “Mental accounting” is a concept that shows how we separate our financial decisions into different boxes in our brains based on subjective criteria such as the source of the money or its intended use. This may seem irrational as money should, in theory, be interchangeable, irrespective of its source or purpose. All money is created equal, but this isn’t what our brain believes.

By recognising that our emotions play a role in our investment choices, we can better understand why we make certain decisions and how to align these with our personal objectives and values. Mental accounting is irrational but it can help us manage our money in a way that makes sense for us on an emotional basis and corresponds to our life goals.

Instead of simply aiming to “beat the market,” investors must take account of their specific situation and risk tolerance with regard to their life goals when creating their portfolio. The greatest risk that you could run here is not properly assessing your situation and your life goals before thinking about constructing your investment portfolio.