Modern Asset Allocation for Wealth Management

CHAPTER 2The Client Risk Profile

In this chapter we take the first of four steps on our journey to finding a client's optimal asset allocation: setting the client's risk profile. The chapter begins with the careful measurement of client preferences regarding risk aversion, loss aversion, and reflection. Standard of living risk is then analyzed via a simple balance sheet model to help decide whether risk aversion and our two behavioral biases, loss aversion and reflection, should be moderated in order to meet the long-term goals of the portfolio. These two steps in conjunction will help fully specify our clients' utility function in a systematic and precise way.

Key Takeaways:

1. All three utility function parameters are measured via lottery-based questionnaires, departing from the traditional qualitative questionnaires for risk assessment.
2. Standard of living risk is introduced as a simple method for turning our single-period problem into a multi-period problem, and is the key metric used for systematically moderating or accommodating risk aversion, loss aversion, and reflection in order to meet long-term goals.
3. The discretionary wealth ascertained from a client balance sheet is a natural measure for standard of living risk and systematically solves the glidepath problem in a concise and personalized manner.

INTRODUCTION

The simplest and most popular approach to establishing a client-specific risk profile is to measure volatility aversion by posing a series of qualitative questions ...