Portfolio risk vs. achievement of goals

Banking | 6 May, 2015 |

Risk tolerance is often the first subject wealth advisors assess when trying to help investors create the ideal asset allocation mix. As a result, determining individual risk thresholds becomes the foundation for portfolio planning. But can this focus on risk actually interfere with the attainment of personal financial objectives?

In determining the appropriate asset allocation for their investment portfolios, many investors (and their well-intentioned advisors) too often put the proverbial “cart before the horse,” focusing too much on minimizing short-term portfolio volatility. While short-term risk tolerance is a key consideration, basing an asset allocation on this alone risks designing a portfolio that may not be aligned with the investor’s long-term lifestyle goals. The answer may be to work “backwards” by first establishing goals and then “backing into” the asset allocation strategy that maximizes – or at least meets the client’s minimum level of comfort for – the probability of achieving these goals.

To help determine the asset allocation that will best help meet long-term lifestyle goals, consider the following questions:

What are my lifestyle goals?

Before entering into any investment plan, first establish specific goals. For many investors, these goals may include: maintaining a comfortable retirement; providing a college education for a family member; not becoming a burden on loved-ones; or perhaps leaving a family or charitable legacy. Whatever the goals, they first need to be clearly defined before an appropriate portfolio can be designed.

What is the current probability of success for achieving these goals?

After establishing goals, attempting to quantify whether or not they are realistic and achievable based upon different portfolio allocations represents the next step.  By analyzing the impact different portfolios may have on reaching your goals, you can determine what asset allocation gives the highest estimated probability of success. It is wise to work with appropriately trained and credentialed financial professionals during this process – they often have the experience and tools to conduct this type of analysis.

What is the potential volatility of the portfolio as it works to meet these goals and can I live with that volatility?

Even after determining the optimal portfolio in this manner, the work is not complete. The optimal portfolio for maximizing the probability of reaching your life goals may be too volatile for you to maintain the strategy for the long-term. Consistency is key to any long-term investment strategy, and you must be able to tolerate the short-term swings that will occur in order to reap the benefits over the long term. If you find that portfolio fluctuations cause you undue stress, you may need to modify your financial goals to fit a more tolerable portfolio.

So what is your real risk? Is it portfolio standard deviation or the risk of not meeting your lifestyle goals? For most investors, it is likely the latter.  For instance, it doesn’t make sense to “protect” your money in an overly conservative account if that allocation virtually guarantees you will run out of money during retirement. You would “protect” your money until it was all gone!  While not always the case, sometimes intelligently increasing portfolio risk will actually increase the likelihood of goal achievement.

To be clear, this is not a suggestion that investors take on more risk than is necessary to meet their financial goals. Rather, investors should determine their asset allocation based less on one-year downside risk tolerance and more on minimizing the risk of not accomplishing their stated goals. By determining asset allocation in this manner, you will become more aware of the effect of the portfolio decision on your life goals. You can then make an informed asset allocation decision, balancing any tradeoffs between short-term portfolio volatility with the achievement of longer-term goals.

Jason Miller is director of financial planning for BMO Private Bank, which offers a comprehensive range of wealth management services that include investment advisory, trust, banking and financial planning to meet the financial needs of high-net-worth clients. 

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