Identifying a client’s risk profile is the most important factor to consider before implementing an investment plan. Items like client age, wealth, cash flow needs, etc. all come together to lead to a single answer to the amount of risk a client can tolerate. But, what does it mean when it is determined that their risk profile is “moderate”?
Most of the answer settles on the asset allocation split between equities, fixed income and cash. As we all know, equities are generally more risky than bonds and cash. But, not all equities and bonds have the same amount of risk so we need to look further into the underlying characteristics.
For example, modeled historical measures of standard deviation of return (i.e., statistical measure of variability around the average return) and “drawdown” (i.e., peak to trough return volatility) are useful to help categorize the risk profile of a portfolio.
Being able to measure the underlying risk of a strategy is critical because simply saying “moderate” does not get you to a universally-accepted approach. For example, I am aware of three funds that have the word “moderate” in their name but have very different approaches and risk profile. Per the table below, you can see that large variation in return and risk. So, though MAMAX has top returns, it also has top standard deviation of return and drawdown! Interestingly, AOM with the lowest return has the highest amount of return per unit of risk (1.54).
So, best that any investment strategy includes a recognition of the underlying metrics supporting the risk profile and not just settle on a name!