Risk Tolerance Lessons from COVID-19
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The COVID-19 pandemic and accompanying market volatility left some investors panicked and others bewildered. Advisors are getting more calls to discuss portfolio risks and client decisions. This tumultuous environment illustrates why a risk tolerance assessment exercise inspires confidence in clients.
Defining risk tolerance
An investor’s risk tolerance incorporates both their willingness to accept and ability to take on risk. This is commonly interpreted to be whichever dimension is the prevailing constraint, and it may change as someone's ability to take risk evolves over time. Some advisors use the term "capacity" or "financial capacity" to describe what regulators term "ability."
Risk tolerance and COVID-19
Naturally, it is the bear market that makes investors most susceptible to making behavioral mistakes (typically investors don’t abandon their risk/growth investments when the market is making new highs). Tumultuous markets such as those experienced during the COVID-19 pandemic leave advisors concerned about previous measurements of a client's preferences for risk and reward. Clients never experienced such a rapid stock market decline of this magnitude, nearly 34% in just five weeks1! During this period, the aggregate bond market also declined nearly 10%, surprising many investors who thought the broad bond market would typically appreciate or hold its value during a large decline in the stock market. Many clients didn’t realize they could lose that much money in such a short period of time. The Depression of the 1930s is thought to be the closest economic comparison because of the massive peak in unemployment rate during both periods.