ALICANTE. Every year the same story. Entities that offer investment services have to update the suitability test for our clients. For this reason, we ask you to fill out the Mifid (Markets in Financial Instruments Directive) questionnaire again, which will inform us about several essential aspects for good advice. We collect information about your investment knowledge, your investment experience, as well as your financial situation and capacity.
With the last update of the regulation we also implemented the ESG criteria -environmental, social and corporate governance-, that the client wishes to include in his investment portfolio. The purpose of this test is to measure the risk that the client can assume and at the same time to know the risk that he really wants for his portfolio. It also tells us in which product families we can invest and especially in which it should not. The client needs to be comfortable and will choose the solution that best suits the risk he is willing to take.
Historically in Spain, the profile most in demand was the conservative one, endorsed by the great aversion to losses felt by the investor. If we refer to the data from the Inverco Observatory’s ‘Savings Barometers’, we see that the investor for a few decades is more willing to choose a portfolio with a little more risk. If in 2016 the conservative profile represented 55%, today it is at 49% (in 2009 it was 62%) and the moderate profile has risen 10 points from 33% to 43%. At the same time, it is observed that the investment time horizon is lengthening significantly, it is no longer focused so much on the short term, but rather it is giving way to the longer term.
For advice, these data provide us with a lot of information about how to approach the service. The client is more and better informed than before and more willing to invest in products and portfolios with a certain level of risk. It should also be noted that with the ‘zero rate’ scenario of recent years, fixed income has not been a profitable alternative and investors have had to increase their risk exposure to obtain returns.
If we add to this the great effort on the part of some institutions such as the CNMV to provide education and financial information –and the fact of having to fill out the suitability tests- we can deduce that the investor is finally seeing the benefits of choosing a more optimal profile for his investment, leaving aside the conservative bias that has historically weighed him down so much.
Here comes into play the Modern Portfolio Theory or Modern Portfolio Theory (MPT) proposed by the economist Harry Markowitz in 1952, Nobel Prize in Economics 1990. If we start from the fact that the investor acts rationally and is risk averse, then he will always choose an investment portfolio with the lowest risk and with the highest return expectations.
This methodology is based on the selection, weighting and combination of the different assets (bonds, investment funds, ETFs, shares…) that will make up the investment portfolio in order to maximize their expected returns for a given level of risk. or determined volatility.
Pay attention to the correlation
In the selection and weighting of the assets within an investment portfolio, we will look at the expected return of each of the assets and the correlation that exists between them. And it is precisely in the correlation where the interesting thing is, the investor can significantly reduce the risk or volatility of his portfolio if he combines assets with negative correlations. We look for the assets in the portfolio to behave contrary to market movements to reduce non-systematic or non-diversifiable risk. However, there is no way to reduce market or systematic risk as it is inherent in the market itself. Therefore, the diversification of assets and the correlation that exist between these assets is key to building efficient portfolios.
For example, we can reduce the volatility of a portfolio if we select assets such as Treasury bonds that have a negative correlation with a fixed income index such as the Ibex 35 or the S&P 500. In this way we achieve a higher expected return for a lower volatility, or the efficient portfolio. If we do this for all risk levels and represent it in a Cartesian graph, we would obtain the following efficient frontier graph or curve. Any combination below this curve should not be chosen by the investor.
The correct selection, weighting and correlation between the different assets in the portfolio is therefore very important in order to improve the expected return at a given risk level.
René Bauch is a financial advisor to the Alicante-based EAF gCapital Wealth Management, EAF that advises the fund Boutique Management gCapital Total Market (ES0116831050). You can contact the author to answer any questions or to be interested in gCapital’s wealth management services by writing to firstname.lastname@example.org or email@example.com
Legal warning: In no case does this publication imply a personalized recommendation or investment report. It is a purely informative article. Under no circumstances can it be understood that this document constitutes an offer to buy, sell, subscribe or negotiate securities or other instruments. Its author is therefore not responsible under any circumstances for the use or monitoring of it.
We wish to thank the writer of this short article for this outstanding content
Opinion | Optimization of the risk-return ratio of an investment portfolio. By @ReneBauch of @gCapital_W_M