Combining risk frameworks with appropriate asset allocation is no mean feat.
Economists call them “teachable moments” – life events which make us think more about long-term financial planning. Until my 40th birthday, I barely thought of my mortality. But since then I have barely thought of anything else.
A major birthday milestone, combined with the arrival of young children, is changing my world view in a way previous life events did not, including getting married and buying a house.
Providing in the long term for the needs and wants of family now looms much larger in my mind. Sure, these impulses to plan for the long term are often crowded out by the relentless turn of everyday life, both at work and at home. Keeping the hours that a baby does is not really conducive to thinking hard about anything.
Financial planning is difficult
More than that, financial planning is difficult. We need a bigger home. The bank’s mortgage adviser (I know, I know, but that is what they call them) dutifully took some basic income and assets details from me, used an algorithm to calculate the sale price of our flat, stress tested affordability using a steep-rise-in-interest-rates scenario, and out popped a number.
The bank had measured its own risk capacity, rather than mine. What I could borrow, not what I should borrow. I came away pondering my own risk capacity and risk tolerance, and the relationship between the two.
Behavioural finance expert Greg Davies recently argued that a proper assessment of risk capacity requires integrating knowledge of an investor’s entire balance sheet (including assets as well as liabilities; and investible assets as well as non-investment holdings), with knowledge of their anticipated future income and expenditure.
How do I discount the present value of my future cashflows?
But how do I discount the present value of my future cashflows? Take two of the biggest items on my personal balance sheet: my home and my human capital (economist-speak for my ability to earn a living). How does one value these assets?
Beware of optimism bias
Many people over-estimate the value of their house, whether because of optimism bias or more structurally because the thin trading volumes which characterise the property market make price discovery difficult.
Human capital’s discounted present value is perhaps even more difficult to project. Individual labour market risk is complex. At the macro level, a well-paid job in your early 40s is strongly correlated with rising income as we enter our peak earning years in our 50s.
But at the micro level, our individual circumstances might look and feel very different. Technological change continues apace. Will a robot take my job? Is my company set to thrive? How transferable are my skills? Does the new boss like me? In a world where change appears ever more rapid, labour market risk appears enlarged.
This brings me to the second problem with measuring my risk capacity – the way in which it is influenced by my low risk tolerance. Objectively, I might have the capacity to take X amount of risk across my portfolio. But I will almost certainly want to take less risk because of my tolerance, since my financial personality is focused on the probability of adverse outcomes.
Equally, I want to take enough risk to make reasonable long-term objectives reasonable. Truly, I need a good adviser to build me an integrated risk framework with an appropriate asset allocation.
The article above was previously published on Aberdeen Standard Investment’s ‘Thinking Aloud’ blog on 28th March 2018