Summary

Description
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Timeline’s risk scoring consists of two important dimensions, the asset risk scale and the volatility scale. The overall risk score is provided on a scale of 1 to 10.

Each of the two components is calculated independently, with the result in one dimension used to calibrate the other. A portfolio will receive the highest risk score as indicated by any of the individual components. We define the final score for the investment as the maximum between the asset risk scale score and volatility score, subject to some normalisation constraints implementing volatility penalisation.

The first step in our scoring process is to assess the proportion of higher-risk assets in the portfolio.

To do this, we have constructed eleven different hypothetical portfolios which are invested in Global Equities (Morningstar Global All Cap Target Market Exposure) and Global Bonds (Morningstar Global Core Bond). Based on the proportion of these assets in the portfolios, we have created ten buckets.

Portfolio 1 is invested in 100% conventionally defensive assets and 0% higher-risk assets, while Portfolio 11 is invested in 100% higher-risk assets. Exposure in higher-risk assets increases by 10% in each bucket while the exposure to defensive assets declines accordingly.

Table 1: Higher-risk and defensive assets of each hypothetical portfolio

An investment is placed in one of the above risk buckets based on the proportion of higher-risk vs. defensive assets in the portfolio. Typically, equities, property, commodities, gold* are considered higher-risk assets, whereas fixed income and cash are considered defensive assets. The risk score assigned based on the asset risk scale is given in the following table.

Table 2: Score based on asset risk scale.
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Although the assignment of a risk score based on the (%) of growth assets (higher-risk assets) is standard and criticised by many, the need is made apparent when dealing with historical indices data. If we map the actual investments into historical asset classes (historical indices), this means in practice that we map each fund to the best suitable index that we have available.

However, the actual fund may be far more volatile than the index that we have selected for historical back-testing purposes. So, if a risk profiler provides a risk score based on historical volatility boundaries, the results provided aren’t definitive.

The second step is to assess the volatility score of the portfolio. We use the same eleven hypothetical portfolios as shown in Table 1 and compute their median 10-year rolling real volatility as follows:

a) We run the hypothetical portfolios in Timeline’s engine for all the monthly rolling 10-year scenarios from January 1915 to December 2023. We run the portfolios with no withdrawal, fees, or tax implications. For each scenario, we rebalance annually the hypothetical portfolios to their target allocations as in Table 1.

b) We compute the nominal annual returns of each 10-year rolling scenario and convert these to real returns, using the annual CPI data for the same period. For example, for the 10-year scenario “January 1915 to December 1924”, we use the annual CPI for the same period to convert the annual nominal returns to real. Then we compute the standard deviation of these real returns and get the 10-year annualised real volatility.

c) Timeline’s first 10-year monthly rolling scenario starts in January 1915 and the last one starts in January 2014. There are in total 1187, 10-year monthly rolling scenarios. We repeat step (b) for each 10-year monthly rolling scenario for each portfolio and form the median of them.

We use the standard deviations (volatility) of the hypothetical portfolios to construct the volatility lower and upper bounds of the buckets as follows.

Table 3: Volatility Score Buckets

We compute the median 10-rear rolling real volatility of the investment in question and see in which range it maps to. We assign the investment to the corresponding volatility risk score. For example, if the investment’s volatility is 9%, it will map to the fifth bucket and the volatility risk score will be 5/10.

The final score integrates the risky assets and volatility approaches. If one examines solely the percentage of higher-risk assets within a portfolio that can lead to a situation where two portfolios with the same percentage allocated to equity have the same risk score, which then disregards diversification.

So, the final score is the maximum between volatility score and assets risk score + 1. The portfolio still gets penalised for holding high volatility assets but not to the extent that it is affected by historical data mapping inaccuracies. The final score ismin(asset risk + 1, max(volatility risk, asset risk)). The final score has as a basis the percentage of higher-risk assets in the portfolio but at the same time, it penalises in a controlled way portfolios with riskier investments.

We are using Timeline’s data from January 1915 to December 2023. Please see here for data sources: Home ǀ Morningstar Indexes

Starting with a 50/50 global investment portfolio we have:

This portfolio acts as the basis for any other 50/50 portfolio.

Consider the case of a 50/50 UK portfolio. Even though the percentage allocated to equity is the same for both portfolios, the lack of diversification in the UK portfolio implies a higher average annual volatility compared to the global portfolio case. The extent to which one can measure the effect of a lack of diversification is optional. One can focus on historical drawdowns, Value at Risk, or even the full history of bear markets and recovery time:

At Timeline we do examine these factors but for risk scoring, we limit our process to volatility which has a greater impact than the pure growth of assets risk scoring process which is heavily used.
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Our process captures the lack of diversification and the final score for a 50/50 UK portfolio is:
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It is in general terms accepted that an investment in fixed income is less volatile than an investment in equity. Even though this is a fact, there is an equity allocation threshold upon which this argument is true. Evidently a 100% global bond portfolio is more volatile than any global equity/bond portfolio where less than 20% has been allocated to equity, and again this is due to a lack of investment diversification. Our risk-scoring process encapsulates this issue and addresses it by looking at the volatility. In this case instead of a risk score of “1” the final risk score is “2”:

Our portfolio risk scoring process is comparative to global portfolio risk. The volatility dimension merely penalises portfolios with the same equity allocation as the benchmark global portfolio but with higher volatility. In simple terms, any given investment portfolio with X/Y equity/bond allocation that has higher historical volatility than the equivalent X/Y global portfolio will receive a higher risk score than the X/Y global portfolio.

The calculated final risk scores get updated whenever the asset mapping process gets updated or changes and whenever the underlying data returns get updated. The final risk scores should not be used on its own to assign a portfolio. It is merely an effort to act as an axis to understand the associated volatility compared to a standard growth of wealth approach.

The attitude-to-risk aspect of an initial review is a collaborative discussion between the adviser and the client. The ratings of the portfolios act as a guide and should serve as a prompt for discussion rather than scripture by which an adviser makes their decision. The final choice of portfolio is mostly reliant on individual client factors. A client’s capacity for loss, sophistication or investment time frames should, in theory, play a more key role in this decision.