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What is the Traditional Approach?
A majority of the financial planning industry at present relies upon three key assumptions when designing investment strategies for clients: The first assumption is that “risk” is measured by volatility – that is, a risky asset is one which has highly variable short and medium-term returns. The second key assumption is that each investor has a consistent personal approach to risk which can be determined, and which provides a reasonable basis for investment strategy.
Thirdly, it is assumed that an appropriate investment portfolio can be constructed by mixing
different proportions of five major asset classes, which have consistent and predictable return and volatility characteristics, to deliver a portfolio to the client with a volatility level that’s consistent with their risk profile.
The role of the planner in this model is to select underlying investment managers or direct
investments within each asset class, and to rebalance the client’s investments each year in line with pre-defined strategic asset allocation and changes in the investor’s circumstances.
The Definition of Risk.
Defining risk as volatility assumes that each asset class has a typical or expected return over a
particular time period, that can be understood and used for planning purposes. Some asset classes’ returns are more predictable than others. Generally, the more predictable returns are over the short term, the lower they also tend to be. More volatile asset classes tend to have a narrower range of expected returns if held for longer periods.
Risk Profiling
A client’s “risk profile” is usually built using a written questionnaire. Clients answer questions which aim to determine their knowledge of markets, and their emotional risk tolerance – that is, how much volatility can they tolerate? Investors then are grouped into one of five categories of risk tolerance based on their answers:
Conservative, Moderately Conservative, Balanced, Moderately Aggressive or Aggressive.
Strategic Asset Allocation
Each of these five profiles has a pre-determined Strategic Asset Allocation (SAA). Each profile has a mix of the different major asset classes, which aims to deliver the maximum potential investment return within the different volatility constraints of each risk profile. By mixing asset classes, the theory of diversification suggests that for a given rate of return, volatility can be reduced because different asset classes perform well at different times – that is, they are not perfectly correlated.