Hi,
I really like this idea but I struggle to define exactly what one would use as an "ideal" reference portfolio. In theory an "imaginary" portfolio is a really good idea because it provides a reference point for investors to compare themselves to. We use a risk appropriate benchmark as a reference for all of our clients so that they can see how they should have done for the risk they took. The benchmark we use is a bespoke blend of index data and therefore excludes all costs and taxes. That's a challenge to compare yourself to let me tell you..... Imagine you are playing tennis and your opponent is Novak Djokovic and you get the idea. So, we also use the client's required return which is the rate they need to achieve and have the best chance of never running out of money. Which again, is fine and a really good idea, the problem is that it is also a straight line - and investments don't move in a nice straight line!!
So my question is this; which portfolio should we use for reference? We could use a portfolio of a typical Irish investor but we know that a typical investor in Ireland has an unhealthy exposure to property, too much cash and inadequately diversified equity investments with a home bias to Irish stocks.
The answer is really that, actually, everyone needs a unique portfolio that is appropriate for their need, willingness and capacity for investment risk and which is consistent with their personal objectives and values about money and investment horizon. Each investor will have different answers to each of these substantive issues, and therefore each should have a unique portfolio.
If we look at the way that many products are sold in Ireland the reference point is "ESMA ratings". That is the European Securities Market Authority which measures portfolios on a scale of 1 to 7 based on their volatility over the last 5 years. Some commentators have argued that the ESMA ratings are meaningless or worse, that they mislead investors. We analysed the volatility of portfolios over a 45 year period and found that in practice over discrete 5 year periods the ESMA ratings of portfolios are fairly stable (with the exception of equities, which up until about 2 weeks ago had been less risky than history would predict)
Let's say for the sake of argument that I could provide 7 model portfolios covering the risk spectrum from conservative to higher risk. That would mean that in order to provide a reference point for most investors I would need to illustrate at least 7 different investment portfolios. So, do we just arbitrarily pick one as our reference?
However, we also need to consider different possible implementations so for example in a tax efficient solution I would use a different set of investments entirely to a pension portfolio in Ireland. This is because some funds are subject to income tax and capital gains tax and some funds are subject to exit tax. So let's say that's another 7 portfolios. However, I actually have two different tax efficient implementations so really another 14 portfolios.
Now, I can also apply a different investment approach to each portfolio range so I could have an active management solution, a passive management solution and a smart beta or what we call Strategic Indexing solution. We have 4 implementations for each option times the number of tax efficient strategies and pension implementations. 7x2x4x3 = 168 portfolios to choose from.
We also have an implementation for Ethical and Sustainable Investing with each 7 portfolios having another 4 implementations depending on the degree of exclusion that the client wishes to apply to their portfolio. We also have implementations for all of the above including and excluding Real Estate and including and excluding Emerging Markets.
Using this simplified methodology we get to something like 5,040 different reference portfolios that I could use to illustrate a single investment of €100,000.
Now, the problem is complicated further by the fact that I don't actually use 7 models for each implementation but actually 100.
So in my universe of possible investment portfolios I actually have a choice of 504,000 different combinations of investments to choose from.
Now here is an interesting observation; many investors are offered just 3 or 5 models.
Google the Financial Conduct Authority and "shoehorning" for the UK regulator's views on investors being squeezed into a narrow range of reference portfolios.