Risk Tolerance in Volatile Markets
by Sheryl Rowling
Managing portfolios for clients is about more than a simple calculation exercise. To properly invest on behalf of clients, we advisors must strive to create strategies that will allow clients to reach their goals while remaining within the confines of acceptable volatility. This procedure, if done properly, involves much more than merely selecting a pre-determined allocation based on a questionnaire score. When the markets are as volatile as they are today, our strategies are truly put to the test – in terms of both goals and clients’ emotional considerations.
The Standard Approach
Typically, the process to determine risk begins when advisors assign a “risk tolerance questionnaire” (RTQ) to new clients before investing. The RTQ will generate a score which is then matched to an appropriate corresponding portfolio allocation. This methodology is simple and easily documented for compliance purposes. After all, if Joe Hotshot’s RTQ score is 4 on a scale of 1 to 5, we’ve got what we need to assign him an allocation of 80% stocks and 20% bonds. But this approach is too simplistic to truly get to the root of how the client feels about risk. There are three additional factors that need to be considered as a part of this process. Let’s explore further.
The More Sophisticated Approach: Risk Tolerance
A skillful advisor must look beyond the single number produced by an RTQ. A questionnaire designed to determine a person’s willingness to take on risk can sometimes result in a misleading answer. The primary reasons for this include the difference in focus between overall attitude and portfolio strategy as well as actual dollars at stake.
Extrapolating investment policy from one-dimensional questions can be dangerous. For example, asking a client to choose between receiving $100 vs. an equal chance of receiving $200 or zero is not indicative of how they will feel if applied to their life savings. My preference is to present possibilities reflecting real numbers. If Steve Skeptic has a portfolio of $1 million and his RTQ indicates he can accept a downturn of 20%, I will translate this into real numbers before recommending a strategy. I will ask, “If the market drops by 30% and your portfolio drops by only 20%, will you be able to sleep at night and stay the course? This means that your one million dollars will drop to $800,000. Could you handle a $200,000 loss under these circumstances?” Quoting actual dollar amounts makes the downside more tangible to clients.
Surprisingly, downside risk is not the only emotional trigger for clients. Limiting upside potential can sometimes be more problematic. For example, Eva Envy’s RTQ points to a portfolio of 60% stocks and 40% bonds. After careful and thorough explanation of the downside risk to her $2 million portfolio, Eva signs an Investment Policy Statement agreeing to the 60/40 allocation. However, after a market surge of 20%, Eva’s portfolio has grown by only 12%. She calls her advisor and expresses her extreme unhappiness at missing out on the full amount of growth she should have earned. How can an advisor address this concern before it happens? Like downside risk, the advisor must quantify the upside limitations of diversification.
Clearly, risk tolerance measurement is more of an art than science. Despite its shortcomings, I would never recommend tossing out the RTQ. After all, the RTQ is “industry standard” and offers tangible documentation of the beginning of the process. It is the advisor’s duty to follow through and document the broadened steps of the process.
The More Sophisticated Approach: Risk Capacity
No matter how risk tolerant the client is, consideration must be given to the client’s capacity to take on risk. For example, an extremely wealthy client will likely have more risk capacity than a working couple with fewer investments. In other words, a client with greater resources can afford downside risk more so than one with lower resources. Indicators of risk capacity include employment status, age, health, outside investments, dependent family members, etc.
The More Sophisticated Approach: Investment Horizon
In an efficient portfolio, higher volatility should translate into higher long-term expected returns. The operative phrase here is “long-term.” If the client doesn’t have a long-term investment horizon, taking on excess risk can be disastrous. For example, a client saving for a down payment on an anticipated home purchase in a year can’t afford to ride out a major downturn without changing their plans. Similarly, an elderly couple relying on their savings for monthly cash flow can’t afford a significant downturn. On the other hand, a millennial executive who regularly adds to her 401(k) and investment portfolio has a long-time horizon to ride out ups and downs.
The More Sophisticated Approach: Risk Required
Financial planning is a critical component of determining an appropriate investment strategy. Quantifying return requirements to accomplish a client’s goals can be translated into an asset allocation. The key is finding the intersection between portfolio risk and required return. If the risk required to produce the desired return is too high, then the client must either adjust his goals or adjust his risk tolerance.
In this time of pandemic-related volatility, we are witnessing the importance of taking the time to choose the correct asset allocation for each and every client.
An appropriate investment strategy is more than picking an allocation based on an RTQ number. It requires understanding the client’s true feelings about risk, determining their risk capacity and time horizon and their required return based on their goals. The process is partly science, as documented by the RTQ results, but it is more art. A well-designed strategy can help a client achieve their goals. However, at least as important is the client’s ability to stick with the strategy through the ups and downs of the market.
Managing clients’ money is about more than just asset allocation, however. The optimal client-advisor relationship requires constant communication and coaching. Our next post will address how regular communication with our clients during this pandemic has made all the difference with regard to “staying the course.”