For at least 15 years, risk profiles, used by banks or independent risk managers to assign each client an investment portfolio, have been the subject of discussion. The current trend change from falling to rising interest rates further complicates client communication. The reason: a static risk profile and dynamic markets are hardly compatible. An analysis.
In 2008, Tom Loonen, then a research fellow of the Vrije Universiteit (VU) Amsterdam and Fred van Raaij, a Professor of Economic Psychology at Tilburg University, sounded the alarm. They had asked 45 private individuals to fill out forms about their financial situation, which they then submitted to six banks in order to compile a risk profile. The result: the client who was assessed as ‘offensive’ by one bank, received the label ‘defensive’ by another. The result: large differences in investment returns.
Investors have no idea
Loonen, now a Professor of Financial Law and Financial Integrity at the same university, oversaw an updated study of 12 unnamed European banks. The study showed that these banks fail to inform customers about investment risks, according to a study printed in the Dutch economics journal ESB and highlighted by the Het Financieele Dagblad (FD) newspaper.
The reason for this is that the risk profiles assigned to clients by their bank can overlap on the one hand, while on the other hand they can differ greatly from one another. Banks and independent asset managers, for example, work with bandwidths in their portfolios, which can be stretched considerably depending on market conditions and the investor’s vision. “Investors often have no idea of this,” Loonen told the FD.
Looking at the results of the 2008 survey and those published in the ESB, one might draw the conclusion that nothing has improved. But the opposite is true. A lot has happened, only the adjustments are marginal if you compare them to the fundamental changes taking place in the world economy and markets. In short, the problem with the risk profile is that it is far too static (“Do you sleep badly when the stock market falls?”), whereas the client portfolio, as a mirror of the markets, should be highly dynamic.
Creeping inflation causes headaches
Take the balanced portfolio, which roughly consists of 60% shares and 40% bonds. For decades, this portfolio has delivered a good result: an average return of around 6 to 8 percent per year. This was due to low inflation, which more or less side-lined business cycles and allowed share and property valuations to reach record levels. But now the music has stopped: over the first six months, there was a double-digit loss and the investment gain of 2021 was jettisoned. Such losses happen on occasion.
But this time there seems to be more to it. Inflation is creeping up, forcing central banks to raise interest rates. At the same time, caution is called for because excessively high interest rates frustrate growth and so the threat of recession is just around the corner. Defining and implementing monetary policy is therefore now a lot like walking on the edge of a razor. The balanced portfolio is particularly vulnerable.
Goldilocks scenario
Over the past 40 years or so, this strategy has lived up to the Goldilocks scenario: «not too cold, not too hot, just good». This was due to persistently falling interest rates. For equity investors, this trend was attractive because it contributed to higher corporate profits and thus higher valuations, while for bond investors, falling interest rates were associated with higher yields.
The Great Financial Crisis of 2008 could have put an end to this trend, had it not been for the fact that central banks such as the Fed and the ECB allowed this Goldilocks fairy tale to continue by keeping interest rates artificially low and turning on the money press to pump liquidity into the markets on an unprecedented scale.
But with the pandemic and the war in Ukraine, two black swans have flown into the radar system of the world economy and markets. The result: faltering supply lines, inflation, rising interest rates, downgraded equities and heavy losses on so-called ‹risk-free› bonds. It makes it clear that the risk profile used is actually no more than a somewhat poor snapshot of the client’s situation, and that the asset manager’s attempt to protect him from the dynamics of the markets with stretched bands does not work either. Because when interest rates rise, the correlation between equities and bonds increases, resulting in rising losses.
No attractive risk-adjusted return
Asset allocation and portfolio construction strategists are therefore increasingly of the opinion that the neutral portfolio no longer offers an attractive risk-adjusted return in the current climate of risks in the area of economic growth and inflation. The diversification in the portfolio is simply too low. If inflation is structural in nature, then it is necessary to shift to asset classes that can protect the purchasing power of investors against rapidly rising consumer and commodity prices. Examples include real assets such as commercial real estate, but also infrastructure, precious metals such as gold and even art and classic cars.
For example, Goldman Sachs now recommend portfolios to its clients that no longer use a 60/40 allocation, but rather spread assets between equities, bonds and real assets, which have become very popular, especially among institutional investors and high-net-worth individuals. They provide better risk-adjusted returns.
Although the world is changing rapidly, and the markets are the mirror image of this, some sayings never lose their eloquence: «The only free lunch is diversification», as Nobel Prize winner Harry Markowitz prophetically told us back in 1952.
This article first appeared in Dutch on Investment Officer NL.