Reconciling investor risk tolerance and optimal capital asset allocation for pension planning

Abstract

In line with demographic changes prevalent in many other developed nations, Malta is experiencing a shortfall in pension funding. The introduction of a third pillar pension scheme may present a solution, however its implementation entails the concerted efforts of various players. The investor requires advice from wealth management service providers in order to construct an ideal portfolio that will yield the desired returns over the long horizon. On the other hand the financial advisor has to properly assess the financial risk tolerance of his client so as to offer him an appropriate asset mix that meets the risk-return trade-off of the client. A client's profile is primarily drawn up by means of a questionnaire which seeks to elicit the level of objective and subjective risk tolerance of the investor. This thesis carried out an analytical review of the whole process starting from a critical evaluation of the relevant MiFID regulations that are binding on the advisor and the type of questionnaires that are adopted. Then it analysed the multidimensional nature of financial risk and the tools available to measure it. Subsequently three hypothetical portfolios catering for a cautious, moderate and an aggressive risk appetite respectively were constructed for seven financial institutions in Malta based on their weighted asset mix. Historical time series were used to compute the expected returns on these portfolios which were then evaluated for their exposure to financial risk. The results obtained showed that risk-adjusted portfolios returns were not all in line with their presumed risk category. Moreover an analysis of the questionnaires used revealed that most of them were not adequately scored and often ignored subjective risk tolerance.It became also evident that more effort has to be made to enhance financial literacy amongst the general public and to combat inertia as regards voluntary pension schemes.