Most wealthy families have likely been through the standard risk assessment process that takes place at the beginning of a new advisor relationship. They are asked to answer a series of boiler plate questions to gauge the level of portfolio volatility that they can stand emotionally, which is often characterized as risk tolerance. The advisor then takes an inventory of the family’s assets and liabilities and considers their financial needs to determine their risk capacity¸ which is their actual ability to take on risk. This information establishes the risk profile for the family, which acts as the foundation for the advisor to build an investment strategy for the portfolio.
Assessing Risk Based on What Your Family Requires
While this typical approach to measuring risk meets all the necessary regulatory hurdles, in our view it is missing one critical component. At Northwood, our definition of risk is ‘not having the funds available at the time you need them to meet all your goals’. In conducting a risk assessment, it is imperative for the advisor to consider the family’s risk requirement as well. This is the rate of return they will need to meet all of their liabilities (goals) throughout their lifetime.
When risk requirement is left out of the equation, investing families can end up taking on more risk than they should. A family may have high risk capacity due to their significant financial resources, and the financial stability they enjoy can also result in a high risk tolerance. This combination can lead an advisor to structure a portfolio that aims for a return that well overreaches what is actually required for the family. This approach of ‘going for the highest possible return’ may seem appealing when markets are in an uptrend. But taking unneeded risk to earn ’higher’ return could result in investment losses in down markets, which can be detrimental to the ability of the family to achieve its objectives.
Taking Unneeded Risk Can Be Detrimental to Your Family’s Capital
Consider the following hypothetical example where a family’s risk requirement isn’t factored into the mix. Under the guidance of their advisor, a wealthy family with both a (perceived) high tolerance and capacity for risk strives to earn an average annual return of 10% per year over five years. The family manages a 10% return in each of the first three years, but in the fourth year suffers a 10% loss. Now to achieve their goal they will need a 34% gain in year five (see Exhibit 1). So what is that family likely to do after year four? Given the fragile nature of risk tolerance (which tends to be high in good markets and low in bad markets!), they might get nervous and go to all cash, abandoning their goal and missing out on any potential market upside in the final year by not being invested. Or they might feel compelled to take on much more risk to ‘get back’ to their long term 10% annual return goal. Neither outcome is likely to yield desirable results for the portfolio.
What if this family, based on a detailed cash flow analysis, actually only required a modest average annual return of 4-5% to meet their objectives? Had the advisor tempered their goal to that level at the outset of the relationship, perhaps more of the focus could have been on preserving capital and ensuring all of the family goals could be funded, leading to a much better and more predictable outcome by the end of the period. In the serious pursuit of wealth management, “Discretion”, as they say, “is the better part of valour.”
Consider the Big Picture When Measuring Risk
In order to ensure the most optimal outcome to the risk assessment process, it is also important that families do so in context of their complete portfolio and not just their investible assets. This includes illiquid assets (i.e., the business, private investments), personal assets (i.e., house, cottage) as well as human capital.
With respect to human capital, if your income stream is less risky (i.e. a teacher’s income might act more like a bond than a stock), your investment portfolio may be able to withstand greater risk. However, if your money is tied up in your business or your income stream is volatile and unpredictable (i.e. an entrepreneur’s or an investment banker’s income might act more like a stock than a bond), then your investment portfolio might need to be more conservative with a focus on preserving wealth and funding both near term and future needs.
Similarly, business owners should take the expected value of their business into account when calculating the asset mix of their investment portfolio. It may be that the ownership of the business already represents a substantial commitment to risk assets and the balance of the liquid portfolio should be tilted toward less-risky assets to ensure capital protection and proper diversification.
At Northwood, we help entrepreneurs and high-performance professionals manage the often challenging transition from wealth creators to wealth owners, which is a significantly different stage of life. These families have already taken substantial risks to create their wealth and do not want to lose it. For these families, we suggest that when they think about risk it should not be in relation to making the most money, but about ensuring all of their goals can be funded (both now and into the future) and protecting what is most valuable to them.
In our initial meetings with clients, we recommend a plan that concentrates on aligning the family’s portfolio to meet their actual objectives instead of trying to ‘shoot the lights out’ because they have the means and inclination to do so. By taking this approach we are better able to ensure that that their financial needs are met while preserving the wealth that they have worked so hard to build.