How Do We Measure Our Client’s Capacity for Risk?

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The investors chief problem and even his worst enemy is likely to be himself

Ben Graham

How Do We Measure Our Client’s Capacity for Risk?

Cornerstone uses standard risk assessment questionnaires to attempt to measure our client’s appetite for risk. However, we believe most clients’ appetite for risk changes from time to time, based on which emotion is driving them at the time, fear or greed. After the market meltdowns of 1974-1975, 2000-2002 and 2008-2009, almost every client’s risk appetite changed. Therefore we believe that these questionnaires are limited in their value and need to be supplemented by more extensive input and reviewed annually. During the 2000’s decade we experienced one of the worst market performances in history with two recessions in 2001-2002 and 2008-2009. Prior to 2008 one could say that we could go back in time to any ten year period and never find a decade where the market did not appreciate. During the 2000’s decade the S&P actually lost money.

Therefore we build our asset allocation models and back test them for this historical decade whenever possible to see what the worst annual performance would have been with that particular model. That gives our client a real world snapshot of what would have been the worst case scenario as a realistic benchmark for what might happen in the future. Past performance is never to be used to forecast future results. However, the problem with most portfolio modeling has been that the models are not realistic enough. So we start with the worst case we can find and evaluate risk tolerance from there.