Strategic Risk Allocation

In 2012 Seeds of Advice began evolving the way it constructs its client’s investment portfolios from the industry standard strategic asset allocation (SAA) method to the innovative strategic risk allocation (SRA®) approach.

The SAA approach to portfolio construction has dominated the Australian investment landscape since the mid-1980s. There is significant evidence to suggest however, that the SAA approach is failing investors. It includes a series of performance damaging constraints that make it almost impossible to add value to a client’s portfolio after retail fees. Industry leaders openly acknowledge that the SAA approach is now well past its use-by date and unstructured benchmark/risk based techniques are experiencing growing support.

Why The New Approach?

The old SAA approach is characterised by a static allocation to the major asset classes (Australian Equities, International Equities, Listed Property, Fixed Interest and Cash). The over-arching effect of this static allocation is to constrain the portfolio manager from investing optimal amounts in the best investment opportunities as circumstances change.

The SRA® approach on the other hand, permits the portfolio manager to extract full value from insights into ‘better’ investment products and ‘cheaper’ asset classes and from the flexibility to structure a better diversified portfolio by using the full range of available asset classes and strategies as circumstances allow or require.

There has been a significant change in market dynamics, particularly in the last decade, which indicates an increasingly persistent correlation between equities, fixed interest products and property. The effect of this is that the traditional SAA strategy of switching from growth assets (equities) to defensive assets (Fixed Interest and Term Deposits) to protect investor portfolios in the event of a market downturn cannot be achieved the way it once was. In other words, SAA constructed portfolios are much less diversified (by risk) than one might suppose and because of their static composition provide no alternative for the portfolio manager to seek diversification elsewhere.

Few would argue that the past two decades have not seen significant advances in risk management and portfolio construction techniques made possible by innovations in thinking and technology, alongside a steady evolution in the development of financial markets and market regulation.

The SAA method was devised more than 20 years ago and despite these developments and advances, an appreciation of these changes has not been incorporated in the portfolio management and financial planning arena.

The conventional approach to investment management is to determine the risk and return of different asset classes and to create an efficient frontier of optimal portfolios, then to split the portfolio between growth and defensive asset classes and lastly, to choose investment managers with the requisite expertise in each particular asset class. This method of investing is known as ‘strategic asset allocation’ (SAA) and it has dominated the Australian investment landscape since the mid-1980s.

The SAA approach to diversification says that the investment manager must diversify both industry & asset sector even if that industry or sector is less attractive. It is done to take volatility/risk out of the portfolio to smooth returns but unfortunately, the trade-off is lower expected returns. To put it another way, investors have not been getting the returns they deserve, for the risk they have been taking.

In addition, the traditional investment manager (SAA) seeks to achieve multiple objectives (e.g. the minimisation of brand risk, peer risk, decision risk and benchmark risk) while simultaneously claiming to maximize returns. It is our belief that these multiple objectives act as constraints that in fact limit the manager’s ability to achieve appropriate returns.

The SRA method removes all portfolio constraints bar a single risk constraint that allows your portfolio manager to entertain a larger number of allowable investments with a greater degree of flexibility, which is expected to result in a genuine effort to maximise returns for our clients. In other words, we expect to deliver higher returns for the same level of risk that you have been taking in the past.

We have all heard the phrase, there’s no such thing as a free lunch. Risk is therefore a necessary part to every investing decision. So you can consider how much risk you do or do not want to take on in the process of investing to achieve the outcomes you want both short term and longer term (our risk tolerance), but there are other risk considerations equally as important that need to be weighed up.

The first is known as risk required. Ultimately, this is the risk that you need to take in order to deliver the outcome you desire. For example, parking all your retirement funds in a term deposit may match your risk tolerance, but the return you will get on your investment is unlikely to be able to produce the amount of money you need to live the lifestyle you want.

The other consideration is called risk capacity. This is your ability to withstand the impact of the risk that you introduce into your portfolio as required. Determining your risk capacity helps to answer questions like, what will the impact be on my goals and plans if the risk I introduce into my portfolio doesn’t deliver the anticipated return?

Balancing Risk

Unfortunately an individual’s risk tolerance rarely aligns with their risk required. Finding the balance between comfort and necessity is the hard part described as the “real risk-return trade-off”.

“This is the point where you are willing to accept some variability in your investment returns in pursuit of an overall return that delivers you to your goals and objectives,” Don’t assume that the emotional risk preference will deliver anything near what is needed to reach your financial goals.

“You should focus on the risk you need to take and then if there is a gap with what you’re comfortable taking, you need to find a way to manage that.”

This may be through seeking out an explanation for what that risk really means and developing a plan to spread the risk over time. You might dial it back as you approach retirement so that as you are reaching the pinnacle in terms of dollars held, the smallest amount of wealth is at risk.

The important questions to ask when evaluating risk are not necessarily the obviously investment related ones. Rather, you should take a much more holistic approach, whether these questions are being asked of a financial adviser or of yourself:

  1. Am I on track to achieve my goals?
  2. If not, how bad could it get and what can I do to get back on track?
  3. As it stands, will I outlive my savings?
  4. Am I exposed to any investment risk that might permanently compromise my ability to achieve my goals and objectives? (For example, one particular kind of risk that if it went badly your portfolio would not be able to recover).
  5. How should I budget so that I can achieve my goals?

Understanding the interplay of risk tolerance, capacity and required risk in setting up your portfolio then helps in ongoing reviews and management.

“The way to manage risk for a person saving for retirement is to identify just how much risk is necessary to achieve their goals, ensure the risks are genuinely well-diversified and to spread the total risk over the life of their investing; dialling the risk down as they approach retirement when they have the most to lose and the least opportunity to recover from a set-back.”