Investments in securities involve the risk of loss. As an investor, you are likely very familiar with those words.[i] This disclosure is supposed to remind folks that any and every investment carries the possibility of losing some or all of its value—an important risk to be aware of. The financial services industry commonly attempts to measure an investor’s ability to cope with this risk through a “risk tolerance assessment/questionnaire.” However, as Michael Kitces noted in a detailed piece on Financial Planning, risk is a broad and complex topic. For investors, it is vital to recognize that many risks—not just loss—exist, and being aware of them will help you put yourself in the best possible position to reach your personal investment goals.
Risk tolerance questionnaires attempt to gauge investor comfort with risk through broad, general questions. For example: How long do you plan to be invested? How large a portfolio loss could you stand? How would you react if markets dropped for several weeks? Based on those responses, a computer and/or finance professional would then craft an asset allocation recommendation and voilà! You have a portfolio that will account for your personal comfort with market volatility. Sounds great, no? However, we believe this approach to investing has severe limitations.
For example, these questionnaires are surveys, and surveys only tell you how people feel on a given day, not necessarily how they will act. Moreover, this frames the biggest investment risk as participating in market volatility. But emphasizing portfolio comfort prioritizes short-term relief over long-term growth, which is potentially a bigger risk if you require your money to work for you in the future. We don’t deny markets make investors feel queasy on a day-to-day basis, which makes it difficult to stay invested for the long term. However, risk is more complex and nuanced than just aversion to negative market movement.
As Kitces’ Financial Planning piece nicely highlights, “risk” isn’t an objective, easily quantifiable entity, and many risk tolerance questionnaires fall short trying to measure it. One major reason: Risk tolerance varies from person to person. Two people could rationally argue 70% exposure to stocks is too aggressive or too conservative—neither viewpoint is automatically right or wrong because it depends on the individual. Heck, definitions of “aggressive” and “conservative” are in the eye of the beholder, too. How folks view risk—what Kitces calls “risk perception”—will also differ. One investor could deduce from scary headlines and a couple down days in the market that a big decline is coming. Another may conclude that stocks will bounce back quickly.
Simply, a broad, generalized survey cannot account for the multitude of subjective factors impacting an investor’s understanding of risk. While loss aversion is a typical cognitive bias among people, everyone and their circumstances are different. Kitces illustrates this well through a hypothetical about how arbitrary investing reference points may influence an investor’s feelings. One investor whose portfolio rose from $1 million to $1.2 million and then fell back to $1 million may see the decline as immaterial and not a significant source of angst. After all, she still has that $1 million. However, an investor who inherited $2 million and then immediately lost $200,000 may be more upset because of his different starting reference point—he only experienced decline. On paper, the first investor experienced a larger percentage loss of -17%, but the second investor’s -10% loss might feel worse to him. It’s hard for a questionnaire to account for the variety of emotions investors, with different situations and experiences, face.[ii]
Uncovering all the ways investors mentally account requires ongoing coaching, evolving conversation and periodic check-ins. Moreover, education is required to see that both of these hypothetical investors’ reactions could put their goals at risk. Plus, if investors only view risk in the context of how much they can handle, they may end up overlooking the actual need for it. Yes, investment in securities involves the risk of loss. However, your portfolio isn’t going to grow if you simply sit in cash, either. Believing you can remove risk from investing is a major fallacy, akin to calorie-free cake—it doesn’t exist.
Beyond hypothetical scenarios, consider how answers to a risk tolerance questionnaire might vary surrounding a recent well-known event: Brexit. June’s Brexit referendum, in which “Leave” won a surprising victory, is the biggest political event of the year thus far.[iii] What if you took a risk tolerance assessment on June 22, the day before the vote, when most experts predicted a “Remain” win and stocks were up? That would mean the status quo—no uncertainty in the immediate future—so you may have felt good about stocks’ near-term prospects.
But what if you answered that same questionnaire on June 24, the day after the referendum, when Britain shocked the world by announcing its decision to leave the EU? Global stocks fell off sharply and pundits not only bemoaned Britain’s future problems, but the fallout for the rest of the world. Investors answering a risk questionnaire that day very well may answer the same questions differently than a mere two days earlier. In this environment, you may be a wee bit warier of markets’ immediate future. You may not believe it was economic Armageddon, but you may have some doubts you didn’t have before, especially given all the noise: It’s human nature. In retrospect, it’s easy to say Brexit would be a non-issue—especially since markets are higher and growth hasn’t tanked—but at the time, many pundits, government officials and investors didn’t think so. And if you were spooked even just a little bit, that could have affected how you reported your risk tolerance—and possibly your portfolio’s composition.
Comfort is important—no mistake about it. However, we believe the most critical risk facing investors is whether or not they reach their personal financial goals. To reduce that primary risk, investors must conquer others. Coaching investors about risks—of all kinds, not just volatility—is a huge service a quality financial professional can provide, in our view. They can help you stay disciplined with your plan when markets get volatile, whether it’s advising against chasing heat when markets are hot or counseling against timing corrections when markets fall. They can also assist you with establishing realistic goals based on your situation and future needs. You can’t aim without a target. Regardless of whether you consult an adviser or not, risks won’t ever go away, but identifying and having a plan to deal with them will help put you in a good position to reach your goals.
[i] Perhaps from this very website!
[ii] In other words, it’s squishy. A technical term.
[iii] We hear a US election on November 8 may rival it, though.