There’s been a lot of research on behavioral finance and investing. In essence, what they’ve discovered is that investors often act in ways that are unconscious, irrational and ill-informed. Furthermore, the most self-assured investors can be their own worst enemies as they look for information that supports what they already believe rather than looking at the information objectively.
It seems to me that many of those negative behaviors stem from one root cause — not pairing the investment portfolio to an individual’s emotional makeup. Put another way, failing to sync allocations with the investor’s ability to stomach risk.
Earlier in my career, I approached risk tolerance in a more haphazard way, basically asking clients how they felt about risk on a 1-10 basis, with one representing stashing money under the mattress, and 10 being “Viva Las Vegas!”
While that approach would give a ballpark idea of how willing the client was to take a risk, it didn’t drill down enough to really quantify how much risk they can take, what they are comfortable with and what ranges of returns were acceptable.
Left to their own devices, people often take an aggressive posture when it looks like the market is going to keep on climbing indefinitely. Then, when a correction occurs, as markets tend to do, they end up making bad decisions predicated upon fear. Following the herd and divesting assets in panic can backfire when the market inevitably bounces back, and may result in standing on the sidelines and missing out on potential growth.
Conversely, some investors can be too conservative and watch everyone else making money while their balance barely moves. They also end up missing out on some potential growth because they — or their advisor — have not taken the time to really ascertain their ability to tolerate risk.
Money riding shotgun
At our firm, we use a software tool called Riskalyze, which allows the advisor to take the client through various scenarios and answer questions along the way. At the end, the client is assigned a “risk number” from zero to 100. I like to think of the risk number as a speedometer, something that everyone can relate to. I ask clients, “how fast do you want to drive when your money is riding shotgun?”
We also use the software to rebalance our model portfolios, and then we assign each of them a corresponding risk “speed.” That allows us to sync a client’s risk tolerance to the appropriate portfolio and provide historic rates of return for that portfolio. Thus, we have portfolios that “go” 92 mph, 20 mph and many speeds in between. The assignment of a risk number allows the client to see a potential range of returns that the portfolio may be up or down in any six-month period so we can determine whether that’s a range the client is comfortable with.
We go through this exercise at the start of the advisor-client relationship, and it proves beneficial when we move through market situations like the current one — with its volatility, sell-offs and corrections — to help alleviate worry, minimize mistakes and be sure clients are not losing sleep at night.
Going deeper
The software is one element of helping our clients understand the need for a portfolio and a plan that will keep them on track in tumultuous times. We explain that we take a buy-and-hold approach and accept the futility of market timing — which is virtually impossible to do successfully because timing the exit and re-entry means you’ve got to get it right twice.
Even then, however, the risk assessment process only works if the client is honest with us and with themselves. There have been situations in which we’ve identified the proper portfolio, but when market volatility comes into play, the client becomes uncomfortable and realizes they may actually be more risk averse than they initially let on. In those cases we sit down, reassess comfort levels and reconfigure the portfolio to a more conservative level.
It's only after we have established the parameters of each client’s tolerance for risk that we can go on to create a realistic, long-range, goals-based financial plan that considers future financial needs. For example, if the plan indicates that the client needs to earn 6% a year to maintain their lifestyle, there’s no reason to create a portfolio that aims to return 10% to 15% but will cost the client their peace of mind.
A financial advisor’s dictum should be the same as a medical doctor’s — first do no harm. Determining a client’s appetite for risk at the onset of the relationship can go a long way toward keeping them from doing financial harm to their future prospects while at the same time maintaining their overall financial and emotional well-being.
