If you or a loved on were scheduled for open-heart surgery would you choose a physician boasting technology from 30 years ago? Certainly not. Yet, when it comes to choosing investments and how aggressive or conservative they are (risk tolerance), many investors have placed their faith (and life savings) in the hands of technology from the 1980’s. Technology that, at best, is incomplete and at worst, is downright misleading.
What exactly is risk tolerance?
Good investment advice is built on the foundation of being able to reasonably assess an individuals risk tolerance. Risk tolerance is a measure of how much investment downside an investor is willing to stomach before changing course. Put another way, crossing one’s threshold for risk is the point at which an investor is “surprised” by the behavior of their portfolio. For example, during the 2008 financial crisis, many who either self identified or were identified by their financial firms as “aggressive” investors dutifully rode the market down until it reached a point of being too uncomfortable and then they sold out – missing out on recovery.
Having counseled thousands of clients during my years in financial services, through both good and bad markets, if I didn’t know better I might conclude that an investor’s risk tolerance naturally fluctuates with the economy. The truth is however, that risk tolerance is actually a psychological trait generally formed by early adulthood, and varies little over time.
Why is it then that so many investors continue to be “surprised” by the markets, and acting on impulse, untimetly making self-destructive decisions? The answer, according to the UK’s Financial Services Authority (FSA), an acknowledged leading international regulator regarding consumer protection, lies in the process most financial institutions are using to identify client risk tolerance (i.e.; that questionaire you answer right before you invest) Though the practice of determining investor risk tolerance dates back to the 1980’s, few companies have updated their risk assessment process from 30 years ago. In fact, a recent report from the FSA (http://www.fsa.gov.uk/pubs/guidance/fg11_05.pdf) cites the following criticisms of common industry practices:
- Risk questionnaires use poorly worded questions and unnecessary language.
- Answer weighting is arbitrary or simply made up, there is no standardization
- 9 out of 11 risk profiling tools sampled were found to be unsatisfactory.
So how can you tell if your risk tolerance is accurate and the amount of risk you are taking appropriate? You could ask your financial firm or 401k provider about the methodology of their risk profiling process, but in many cases they won’t know.
One of the many benefits of leaving the world of big financial services companies is that I no longer have to use products, processes or services simply because the back office tells me to. On the contrary, as a independent, registered investment advisor (RIA) and fiduciary for my clients, I enjoy the advantage of being able to choose the resources and solutions that make the most sense for my clients.
As part of our approach to risk management, we partner with FinaMetrica for risk assessment and MoneyGuidePro for financial planning. In doing so, we are able to identify, communicate, and incorporate more realistic expectations for our clients regarding:
- Risk Tolerance – how much downside you can comfortably stomach
- Required Risk – how much risk you actually need to reach your goals
- Capacity for Risk – the extent to which your investment strategy can withstand negative events without seriously jeopardizing the achievement of your goals
Our process helps our clients make more informed financial decisions and experience fewer “surprises.”
We partner with Finametrica for risk assessment and MoneyGuidePro for financial planning.