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K⁴ Portfolio Selection
Complete and Unique Investor Suitability and Profiling
By Ted A. Ponko, CFA

At the close of a trade show, a vendor was handing out T-shirts emblazoned with his logo. A petite young woman approached and asked if he had any size mediums. Upon being informed they were all extra-large, she commented on the fact that it must be a situation where one size fits all. "Actually," the vendor laughed, "it’s more like one size covers all, and in many instances, they don’t do a good job of that."

Sadly, that description applies to many of today’s attempts at investor suitability and profiling. They start with a few general questions about net worth, income, and investing to determine suitability. The profiling process which follows can be equally cursory. Simple questions reveal that the client wants the highest possible return, wants to avoid risk, would like a current income stream, and would prefer the portfolio to be liquid. To resolve the conflicts inherent in these goals, the scoring in these profiling processes just splits the difference and places most investors in the "balanced" portfolio. If the investor is younger, it might be a somewhat more aggressive mix relative to older investors who may fall into a somewhat more conservative mix, but they’re all "balanced" and very similar. Like an extra-large T-shirt on a medium frame, one size is covering all, but it’s not truly fitting.

THE PROBLEM

The problem doesn’t lie with the investor. It is reasonable and certainly understandable to desire high return, low risk, current income, and liquidity; it’s just not practical. Instead, the problem stems from the way the profiling process reconciles conflicting objectives. Quantitative approaches assign points to responses, then average the aggressive (e.g., more return) with the more conservative (e.g., less risk), resulting in the "balanced" recommendation. Some profiling processes may be designed to always favor one factor (e.g., risk control) over all others. This overarching element handles conflicts, but unless the selected element is truly the investor’s primary concern, the result still is not a good fit.

And that brings us to the heart of the matter. Not only do investors have conflicting goals, they have differing preferences among them. Some investors may be exceptionally risk averse. While they would certainly like higher returns, controlling risk is really their key concern. Others may care less about the short-term risk to their portfolio and care a lot more about receiving a consistent level of annual return. A profiling process that simply averages their stated goals without considering the weight they place on each will likely recommend a balanced portfolio for both investors, even though their primary concerns are quite dissimilar.

THE SOLUTION

The ideal solution should specifically address the investor’s goals and the weights he or she places on each of them. The ideal solution should rigorously resolve conflicts between competing goals when considered together rather than simply averaging them or by arbitrarily putting more emphasis on one goal relative to the others. The ideal solution should deliver the recommendation with the highest probability of achieving or surpassing the investor’s acceptable levels of performance for all goals. The ideal solution that meets all of these parameters is Klein Decisions’ K⁴ Portfolio Selection.

K⁴ Portfolio Selection is an internet-based investor suitability and profiling tool powered by Klein’s patented decision process. K⁴ Portfolio Selection evaluates both the investor’s preferences and objectives to resolve the conflicts inherent in investment decisions and investor goals. Based on this analysis, potential portfolios are rank ordered on their expected ability to meet or exceed the specific investor’s goals. The portfolio most likely to produce the highest level of satisfaction for that investor rises to the top. Suitability considerations may eliminate certain alternatives and the investor’s income requirements and unique constraints may flag others as potentially unacceptable, but, like a custom-tailored suit rather than an ill-fitting T-shirt, the result is the unique solution for that particular investor.

THE INPUTS

Although its results are powerful, K⁴ Portfolio Selection is remarkably simple to use and understand. Designed so that it can be used by an advisor and investor together, it not only solicits the necessary information for the suitability and profiling process, it helps spark an open-ended discussion about setting realistic expectations and objectives. Despite its rigor, there are no complicated forms to complete or calculations to perform. Instead, a few visually pleasing and engaging screens gather the information required to perform the sophisticated analysis "under the hood."

The experience begins with a short series of questions focusing on traditional suitability issues (e.g., net worth, current income and investment experience) and cash flow requirements. Cash flow expectations replace the oft-misunderstood concept of "time horizon" in order to focus the question on "when you need your money."

By segregating the traditional suitability and cash flow issues from the investor’s risk and return expectations, K⁴ Portfolio Selection separately assesses what is suitable for the investor and what the investor wants to achieve. Traditional questionnaires combining these elements into one scoring mechanism make flawed assumptions that systematically bias the results in a manner often counter to the investor’s objectives. Most advisors will recognize situations where a traditional approach resulted in a more aggressive recommendation simply because the investor was younger (or had a longer "time horizon"). K⁴ Portfolio Selection avoids this by separately assessing portfolios based on what the investor wants to achieve and what is suitable to implement. In general, a more aggressive portfolio may be suitable for a younger investor, but the investor’s objectives and preferences should drive the recommendation. There is also the opportunity to declare investment constraints such as tax considerations or asset class limitations. Responses to these initial questions are used to determine portfolio suitability and shape the values illustrated in subsequent sections.

The traditional suitability questions are followed by a short series of questions focusing on risk and return as well as the importance of each. Questions cover issues like minimum acceptable investment return, desired participation in up markets, and tolerable chance and size of annual losses. Rather than simply posing these questions in a vacuum, K⁴ Portfolio Selection uses specific figures based on the investor’s prior responses and the recommendable portfolios, tying them to his or her particular situation. Each is posed in a simple, interactive graphical format, giving the investor the opportunity to see the consequences of potential responses. A slider is used to set the acceptable level, and the significance of the factor is assigned by clicking on one of five buttons at the bottom of the page, ranging from "Extremely Important" to "Not Important."

Once the individual importance of each goal or decision factor is established, the investor is then asked six trade-off questions to set the relative importance between pairs of conflicting goals. Is it more important to achieve higher expected average return or better performance in up markets? Would the investor prefer smaller losses in bad years or a lower chance of loss in any year? Again, K⁴ Portfolio Selection presents these choices in a user-friendly graphical format. Each option in the trade-off is placed on one edge of the screen with five buttons running between them. If the investor is indifferent between the two choices, the box in the middle, "Equally Important," should be selected. If the investor favors one factor over the other, one of the two boxes on its side of the page should be selected ("More Important," "Much More"). This is all the necessary participant input. K⁴ Portfolio Selection can then determine the portfolio with the greatest probability of success across all of the investor’s objectives, even if they are competing.

THE RESULTS

The widely accepted technique known as Adaptive Conjoint Analysis is the key to the K⁴ decision process. This statistical technique has been used in market research for years to discern consumer preferences. Applying this to the investor-profiling process, K⁴ Portfolio Selection resolves the conflicts in the investor’s responses in an easy-to-understand, straightforward manner and quantifies the importance of each objective. The acceptable range of outcomes and priorities for each objective is summarized for review, and the investor can revisit prior screens to make any desired changes.

K⁴ Portfolio Selection uses this data to assess each of the alternative portfolios. Using hundreds of Monte Carlo simulations, the investor’s objectives and priorities are concurrently analyzed to determine which portfolio provides the greatest probability of success. This process is fueled not only by the investor’s weighted preferences and constraints but also by market assumptions and the available portfolios. Potential portfolios as well as the investor’s current asset mix are scored and rank-ordered based on the probability of achieving the investor’s acceptable performance levels. Scoring is done on a one hundred-point scale, and the advisor has the ability to set a cutoff for the minimum acceptable score. Separately, suitability is assessed based on the investor’s suitability metrics and cash flow requirements as discussed above to present the portfolios that the investor should consider – or avoid. Alerts are displayed for portfolios that may not be suitable because of the investor’s experience, age, cash flow requirements, or unique constraints. The alternative portfolios are displayed on a bar chart where longer bars indicate strategies that are more likely to achieve acceptable levels for each of the four objectives. A traditional Efficient Frontier comparing the alternatives’ levels of risk and return is also provided.

In many instances, several portfolios will surpass the minimum required level, with the highest scoring representing the best fit for the investor. But in other situations, unreasonable objectives by the investor may not generate a good fit among any of the available portfolios – leading to a perfect opportunity to discuss expectations prior to implementing a portfolio. This isn’t a one-size-fits-all solution, but rather one that’s carefully tailored for this particular investor. By selecting any of the alternative portfolios, investors can see the projected results for the current and suggested portfolios relative to their objectives and priorities. This information is presented in an easily understood graphical manner and presents an opportunity to judge the fit between objectives and recommendations prior to implementation. Any of the previous screens can be revisited if the investor wishes to alter his or her responses. As a final step, the advisor can print a report detailing the investor’s responses and the recommended portfolio. It can serve to document the recommendations and is valuable for compliance and suitability purposes.

A TRUE FIT FOR THE ADVISOR AND THE INVESTOR

Don’t be misled by K⁴ Portfolio Selection’s ease of use and client-friendly interface. This isn’t a one-size-fits-all approach for the advisory user, either. Behind the scenes is a rigorous calculation engine that requires market assumptions, asset classes, and portfolios. The suitability questions must be scored and their totals mapped to specific portfolios. There are also choices in regard to the specific suitability questions and potential constraints. These include the ability to set the minimum acceptable probability for satisfaction of cash flow needs and the minimum acceptable level for portfolio fit. The advisory user can have as much control over these inputs as desired, from using internally developed market assumptions, portfolios, and questionnaires to using a default setup created for K⁴ Portfolio Selection in association with Prima Capital Management, Inc¹. Those who have already developed their own suitability questionnaires or asset allocation models may opt to have them incorporated into the tool while those desiring a complete solution can use all the defaults. Regardless of the choice, K⁴ Portfolio Selection’s robust administrative functions allow easy set up for inputs, defaults, and branding.

K⁴ Portfolio Selection’s interactive structure engages both the advisor and investor in the profiling process, helping to strengthen their relationship while setting reasonable expectations. The graphical interface clearly illustrates alternatives and tradeoffs between conflicting objectives. The advisor can be confident that K⁴ Portfolio Selection resolves these in a highly accepted and highly structured manner. The result is not only a superior suitability and profiling process but also an excellent tracking system for compliance purposes. In the end, the investor has not only provided valuable input, he or she leaves with a better understanding of how the factors interact and greater confidence that the recommended portfolio is the correct choice. Finally, the results can be saved and documented as an excellent starting point for subsequent client meetings or portfolio reviews.

K⁴ Portfolio Selection is a tailored solution for both advisor and investor. Unlike traditional profiling tools where the advisor and investor have little impact on inputs or results, generating the "one size covers all" situation, K⁴ Portfolio Selection allows them to personalize the process to yield investor-specific results. More importantly, K⁴ Portfolio Selection doesn’t just average conflicting responses; it resolves them in a manner unique to both advisor and investor. The result is the best fit for all involved – something rarely achieved with the customary approach.