You make some interesting observations about measuring risk in a retirement account, saying that “the securities industry and the government bodies that regulate it have this [measuring risk] backwards.”  Can you elaborate on this, and explain how advisors should think about risk when structuring portfolios?

DeMuth: It is posited that investors have an inner psychological state known as their “risk tolerance” – one that might be accurately self-reported, measured by a questionnaire or discerned through probing questions from a skilled advisor.  As a psychologist, I am unaware that such a trait exists – I believe that research would show this construct to be situation-specific.  However, even if this trait did exist, it would be a terrible guide to investment decisions.  Investors should invest in whatever way has the greatest likelihood of meeting their financial objectives.  A motorcycle daredevil might require a conservative allocation, and a librarian might require an aggressive allocation.  The advisor’s task is not to take the risk temperature and design the portfolio around that – this is sanctioned malpractice.  A client should not be sleeping soundly at night if “The advisor needs to create a portfolio to meet the client’s goals and then educate the client about the need to endure whatever volatility is required to get there.“his low-risk portfolio is on track to under-fund his retirement.  The advisor needs to create a portfolio to meet the client’s goals and then educate the client about the need to endure whatever volatility is required to get there.  Short-term volatility is precisely what clients are getting paid to endure for the sake of long-term returns that are better than T-bills, and this is a terrific trade-off for anyone with a long-term investment time horizon.  I often find myself telling clients things like, “I’m not going to promise you that we’ll get these returns, but I will promise you that there’s going to be a year when your portfolio will be down 15 percent or even more.  That part I will guarantee.”

Anyone can find investments (after enough trial-and-error) to meet his or her investment risk tolerance.  The advisor can take the client to the next level and construct a portfolio that will meet his or her financial objectives.  Then the advisor’s task is to keep the client in the chair during the promised market downturns.  These are things that most investors cannot or will not do on their own. 

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