In the standard framework of portfolio management, changing a client’s exposure to risk is essentially analogous to changing their overall exposure to risk assets. Want conservative growth? Invest in a portfolio with 40% equities and 60% fixed. Want a more moderate growth portfolio? Increase to 60% equities. More aggressive growth? Allocate your portfolio further towards an equity tilt. At its core, the proposition is pretty straightforward: increase your overall portfolio allocation increasingly towards risk assets to increase the overall risk (and hopefully, return) profile of the portfolio. But what if there was another way to increase overall risk? What if, rather than increasing overall risk by adding a little risk to the whole portfolio, the risk was increased by adding a lot of volatility to a very small portion of the money?
The inspiration for today’s blog post comes from a recent email correspondence I’ve had with Professor Meir Statman (author of What Investors Really Want), and some concepts tying in with Statman’s Behavioral Portfolio Theory work with Professor Hersh Shefrin. In particular, Statman posted a very interesting a basic question about risk management and exposure from a (Fidelity) risk questionnaire that I found fascinating:
If you could increase your chances of having a more comfortable retirement by taking more risk, would you:
a) Be willing to take a little more risk with all of your money?
b) Be willing to take a lot more risk with some of your money?
The standard process by which most planners increase client risk is essentially option (a) – to increase the overall equity allocation of the portfolio, taking a little more risk based on the overall allocation. (Of course, in practice this may involve rotating a portion of the portfolio into equities, but imagine for the time being the advisor implements the change by selling a single conservative growth balanced fund to buy a moderate growth balanced fund.)
Yet in practice, when the average consumer is surveyed about how they would rather take on risk, the response is actually strongly in favor of (b). The reason seems to anchor around our tendency for mental accounting: to compartmentalize buckets of money into separate groups and account for them separately, even though they are ultimately all part of the same personal balance sheet. For instance, when we think about our brokerage account as a separate asset from the account with grandma’s inheritance, and investment them differently, it’s because we’re mentally accounting for grandma’s inheritance in a different manner than the brokerage account, even though ultimately both are theoretically interchangeable accounts and/or could be merged at any time.
In the context of risk investing, the tendency for option (b) is a reflection of this mental accounting behavior. We feel more comfortable knowing that the majority of our money is "safe", and it makes us more comfortable to take greater risk with the small remainder – even if we ultimately end out with a portfolio that, in the aggregate, has the exact same risk profile as a more balanced moderate risk portfolio.
Yet despite our behavioral tendency to prefer portfolios of this nature, it’s often not how we invest for clients. Arguably, the concept of "core and satellite" investing is somewhat similar – we have a steady core that we account for in one manner, and then we invest more creatively and with more risk in the satellite positions, taking potentially much greater risk with a very small portion of the portfolio. However, even in the context of core and satellite investing, if a client wanted to increase the risk of the portfolio, most advisors would likely increase the amount of risk in the core, not just buy even-more-aggressive small satellite positions.
In truth, to really invest in this manner could entail a dramatic change in portfolio construction. Instead of holding balanced portfolios of fixed and equity/risk assets, the client might hold an overwhelming majority of assets in cash, and complement it with "ultra" risky assets, such as the most volatile equity investments, or perhaps even options or leveraged exchanged-traded funds or mutual funds (e.g., 2X or even 3X leveraged funds).
This is not to say that all clients should go out and buy ultra-risky investments immediately. But the underlying point is still there – if the behavioral research suggests that clients actually prefer portfolio risk management approach (b) over (a), how might you invest your portfolios differently for clients?
So what do you think? Have you ever seen your clients express a preference for (b) over (a), perhaps implied with some of their investment decisions? If this was the "preferred" way of investing, how might you guide clients differently about their investments?