Westmount Risk Score
Clients first. It’s our North Star. You’ll see it in every aspect of how we do business. We’re independent – you’ll enjoy access to a greater range of investments. We’re transparent – you’ll always know where you stand with our clear fee structure. And we’re ambitious – you’ll benefit from our drive to find greater opportunities to improve your portfolio returns while moderating market volatility.
The Theory
Investment theory relies heavily on the concept of the trade-off between risk and reward: the higher the expected return, the riskier the investment. This concept makes intuitive sense since it applies to so much else in life: if I drive faster, I get to my destination faster, but at an increased chance of an accident (or getting a ticket).
From our review of behavioural psychology literature and its lessons for investors, we understood that most investors do not have a strictly linear relationship in their assessments of risk and return. The research suggests that they generally dislike losses about twice as much as they like gains. This preference makes them more likely to make riskier decisions to avoid a loss than to achieve a gain.
Other research has demonstrated that people suffer from other biases as well, like the recency bias (recent events tend to weigh more heavily in decision making than potentially more relevant events further in the past) and the framing bias (decisions are made relative to a piece of information that is provided). In addition, it is reasonably clear that investors don’t look at their net worth as a whole, but instead have “wallets” to help them in achieving particular goals. Investors may, moreover, have different comfort levels with assuming the risk of missing a goal for each wallet; they may be willing to accept retiring later, but they must have the money available when a child is starting university.
Risk Aspect
Each of the questions you completed has been applied to at least one of these risk aspects.
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Capacity
The ability of a client to experience losses without dire consequences
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Tolerance
The emotional comfort with experience of losses
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Perception
The view the client has about the current riskiness of the market
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Knowledge/Experience
The client’s experience with investing
The Score
We think that a risk tolerance score should measure the point at which one begins to feel queasy looking at a portfolio statement with losses. Yet risk tolerance scores have typically been determined through answers to a short list of questions that cover most of the risk aspects above, but then aggregate the answers to create a score that is argued to be a measure of your risk tolerance.
The standard questions also don’t take into account an individual’s specific situation. We also considered whether each of the risk aspects were equally important in understanding your risk profile. We don’t think so. Knowledge and experience may make you more comfortable with risk, but if you don’t have sufficient investments to absorb losses and continue to pay your mortgage, this comfort level is irrelevant.
In the end, we think that risk capacity (ability to absorb losses) and risk tolerance (aversion to losses) are the most important aspects in assessing your risk profile. So we derive our risk score primarily from the results of the questions related to these risk aspects. The results of the other two (Knowledge & Perception) aspects have a small impact on the final result.
And it works
Interestingly, we included a self-assessment question on risk tolerance at the end of the questionnaire. It is there in order to help us validate the risk tolerance score we achieve from the other questions. So far, we have found that there is a strong agreement between our score and the answer provided by takers of the questionnaire.
Have questions?
Reach out to your Portfolio Manager