Portfolio Construction

Retirment

Limits of Risk Profiling

Background

There are numerous risk profile tools used to determine a client’s attitude to risk, ranging from detailed psychometric questionnaires through to very simple short form documents. The output of these questionnaires will typically map to a predetermined risk profile that provides an investors suggested asset allocation, taking into account their attitude to risk.

Limitations

However, this process is limited in its ability to incorporate investor objectives, particularly more complex retiree objectives. Also, many risk profile questionnaires base their definition of risk on measures such as standard deviation and do not account for risks particularly relevant to retirees, such as longevity risk (the risk of outliving savings) and inflation risk.

In Lonsec’s view, the risk profiling process is useful to determine an investor’s attitude to risk, however, risk profile questionnaires generally fail to determine how much risk an investor needs to take to achieve their specific objectives, or their capacity to take that risk.

Measuring an investor’s capacity to take on risk is the key factor to aligning an investor’s objectives with an appropriate risk profile.

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