Morningstar - Q4 2021 - 59

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Too Much Risk
EXHIBIT 3
an investor who scored 50 on the Morningstar
Risk Profiler. It shows that when AS is taken
into account, it is close to zero for most of
the range of MPRS values. However, when it is
not taken into account, it can be quite large.
EXHIBITS 3 and 4 show that not taking AS into
account leads to portfolios that have higher
expected returns than those that do-but at the
cost of poor alignment with the target-allocation
indexes and portfolios that are unacceptable
to many investors. To see this, EXHIBIT 5 shows
the compositions of the portfolios at the
breakpoints of the MPRS ranges for an average
investor. These breakpoints are at MPRS =
25, 35, 55, and 65.
Consider the portfolios for MPRS = 65. When
AS is not taken into account, there is no allocation
to U.S. equity funds and large allocations
to the Foreign Large-Cap Growth Fund and the
Emerging-Markets Fund. In contrast, when
AS is taken into account, the allocations to
U.S. equity funds are large, with modest
allocations to the Foreign Large-Cap Growth Fund
and the Emerging-Markets Fund. This reflects
the home country bias of the target-allocation
indexes, which in turn, reflects the asset-allocation
preferences of typical U.S. investors.
Conclusion
As financial advisors face know-your-client and
know-your-product requirements, tools such
as the Morningstar Risk Profiler, the Morningstar
Portfolio Risk Score, and the Alignment Score
are becoming increasingly important to advisors
and their clients. As I have discussed here,
these tools, taken together with the Risk-Comfort
Range, allow advisors to form portfolios
that are both at the appropriate level of risk for
the investors and meet advisors' expectations
regarding asset allocation. K
Paul D. Kaplan, Ph.D., CFA, is director of research at
Morningstar Canada. He is a member of the editorial board
of Morningstar magazine.
The author thanks Thomas Idzorek for helpful comments
and edits.
MPRS
Source: Morningstar.
MPRS
15
Too Little Risk
Marginal (Low End)
Comfort Range
55
Marginal (High End)
Too Much Risk
110
Morningstar Portfolio Risk Score Versus Expected Geometric Mean Return
With Risk-Comfort Range for Average Investor
25
Morningstar Risk Profiler Score
Target Allocation Indices
Target Allocation Frontier
Comfort Range
25
Morningstar Risk Profiler Score
Target Allocation Indices
Target Allocation Frontier
Eff. Frontier (AS Not Taken into Account)
Eff. Frontier (AS Taken into Account)
4
5
Marginal (Low End)
Too Little Risk
MPRS
Source: Morningstar.
Too Little Risk
EXHIBIT 4
MPRS
Alignment Score Not Taken into Account
Alignment Score Taken into Account
Marginal (Low End)
Comfort Range
55
Marginal (High End)
Too Much Risk
110
Morningstar Portfolio Risk Score Versus Alignment Score With Risk-Comfort
Range for Average Investor
Alignment Score Not Taken into Account
Alignment Score Taken into Account
30
Alignment Score
45
15
Too Little Risk
Marginal (Low End)
Comfort Range
55
Marginal (High End)
Too Much Risk
110
30
Comfort Range
55
Marginal (High End)
Too Much Risk
110
3
2
1
4
5
3
2
1
Eff. Frontier (AS Not Taken into Account)
Eff. Frontier (AS Taken into Account)
50
75
50
75
100
Too Little Risk
Comfort Range
Marginal (High End)
Too Little Risk
Marginal (Low End)
)
Morningstar Portfolio Risk Score
100
25
50
25
50
75
Expected Geometric Mean
100
6
Expected Geometric Mean
6
Alignment Score
45
morningstar.com/lp/magazine
59
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