How much risk can you handle?

After the COVID-19 pandemic hit markets, some Australians might be thinking about implementing wealth preservation strategies.

Average household wealth fell 2.3 per cent, down $9,982 to $428,585 per person in the March 2020 quarter, the largest fall since the September quarter 2011, according to recent ABS data.

Falling superannuation balances and stock valuations, down 8.2 per cent and 5.3 per cent respectively, contributed most of the declines. Share prices are tipped to remain volatile, and investors should be ready for more market swings as the COVID-19 pandemic continues to roil financial markets.

Given the volatility, investors need to be more mindful than ever of how much risk they can tolerate within their portfolio. This includes deciding how much to invest across risk assets such as shares and property, and how much in lower-risk cash, says Drew Meredith, managing director at financial planning firm Wattle Partners.

“Having now experienced both the Global Financial Crisis and COVID-19 meltdown, I know firsthand that clients and our team were far more prepared for the volatility than before,” Meredith says.

A key reason for this is regular discussion and communication around clients’ tolerance to risk and the many different risk levels of the investments in their portfolios.

“During the GFC, as many as 50 per cent of our clients were seeking to sell near the bottom, capitulating, primarily due to an apparent overweighting to equities at an important time in their lives.

“But this time around, the number was closer to 1 per cent, as our process had ensured every client’s portfolio clearly matched their requirements.”

Measuring risk tolerance

Risk profiling tools are often used by financial advisers to help determine appropriate investments for their clients. FinaMetrica specialises in risk profiling, and was acquired by Morningstar when it purchased parent company PlanPlus Global in March.

Nicki Potts, a director of product management at Morningstar says risk tolerance is like other psychological traits in remaining mostly stable over time and in varying market conditions.
“Most people do not change from being an introvert one day to an extrovert the next, nor does their risk tolerance change,” says Potts.

“Individuals largely test the same after a crisis as before.”

The chart below, based on data from FinaMetrica, is based on more than 1.2 million risk tolerance tests conducted globally between January 2008 and April 2020, spanning the GFC to the Covid-19 crash. Risk tolerance, globally and in Australia and New Zealand, UK and US, stays at an average of around 50, on a scale ranging from one to 100.

“Sure, there is some variation, but not in magnitude nor is it very correlated to market movements,” says Potts.

Source: Morningstar

The FinaMetrica tool uses psychometrics — the marriage of psychology and statistics — to measure a person’s financial risk tolerance.

Paul Resnik, chief executive of the Financial Suitability Institute, agrees with Potts’ view that risk tolerance is like a personality trait in that it doesn’t vary much over an individual’s lifetime.
“During and after major financial upheavals, it’s sensible to review how our financial plan is progressing,” he says.

“Many of us sleep a little better when we know what’s achievable and what behaviours we need to change.”

Be wary of labels

Scott Keely, a financial planner with Wakefield Partners, which uses its own risk measurement tool, says it is important for investors to check investment labels. For example, he says some superannuation funds offering ‘balanced’ investment options often involve more risk than the term ‘balanced’ might imply.

“We have long known that many super funds will define balanced in a totally different way to what I, as an adviser, or my client, would,” he says.
“Instances of default balanced fund options containing 80 per cent to 90 per cent growth assets (shares and property) assets are not uncommon.”

Such funds will likely outperform impressively during good years, but can lead to disappointing outcomes during a downturn such as we’re currently experiencing.

Wakefield’s Meredith agrees with Kelly’s view, noting the COVID-19 crash has hit many industry funds, particularly investors in the balanced portfolios.

He singles out mismatching or misstatement of portfolios and asset classes as one of the biggest problems during the recent market crash.

“The industry fund sector has been a major cause of this, with some balanced options holding as little as 10 per cent in low risk assets and some holding 50 per cent, making it very difficult for disengaged investors to understand,” Meredith says.

He notes that many super members in March and April flocked to balanced portfolios because of their expectation for lower risk: “But this was the worst possible time, as it became clear that their portfolios carried more risk than their labels suggested.”

“This isn’t restricted solely to industry funds, with many advisers relying on and using similar approaches,” says Meredith.