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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.
Measuring risk tolerance
There are different ways to measure someone’s willingness to accept risk, and they incorporate different aspects of personality and psychology. Some products use a psychometric profile to measure an underlying or inherent element of personality, specifically how risk-seeking to risk-averse someone is compared to a population who’s taken the same exam. The main benefit of this methodology is that it tends to be the most stable measurement because it measures innate personality and is general in nature. Psychometric profiles may also be used to measure other innate personality traits, such as how introverted or extroverted someone might be or how optimistic they are compared to a population. Some profiling tools measure a person’s preferences for balancing risk and reward.
Academics note that preferences often change, anchoring towards recent experiences. For this reason, advisors are often cautious or wary about relying too heavily on preferences measured in the typical “benign” market economy, as they generally don’t provide any reflection or estimation of someone’s preferences during a bear market. It is difficult to gauge preferences during a bear market in advance.
Although less popular, there are profiling tools designed to measure and incorporate someone’s perceptions of risk, which may guide their behaviors. The challenge advisors (and academics) observed is that humans are notoriously poor at correctly perceiving risks. So, incorporating the client's perceptions of risk are often inspire them to "sell low and buy high," classic behavioral mistakes in investing.
Advisor observations
My conversations with a variety of advisors that my firm, Tolerisk, serves shows the following:
- These events cause clients to question or challenge their risk directive. Re-measuring their preferences confirms the change in their preferences and leads to a reduction in risk, often after the market has sustained substantial decline.
- If advisors suspect that a client is panicking during a bear market they will only seek to confirm the objective information, such as retirement horizon, savings rate, spending patterns, future capital expenditures, anticipated capital inflows, and retirement income streams – all used to update measurements of the client's ability to take risk. These objective measurements aren't susceptible to potential recency bias or anchoring on recent experiences.
- Clients who make risk-directive decisions based on a two-dimensional assessment rooted in their unique cash-flows are generally more confident in their decisions and less likely to question them during periods of market chaos.
- Measuring the reasonableness of the client's assumptions, by examining their probability of running out of funds, increases the advisor and client's confidence in the decisions made. In particular, they cite the fact that Tolerisk incorporates the uniquely evolving asset allocation and custom mortality probabilities as big drivers of confidence for both parties.
Summary
Market chaos reminds advisors and clients of the need to make good decisions about risk before volatility ensues. Tailoring their risk-tolerance assessment to the client’s unique circumstances, including cash flows, taxes, and mortality statistics drives client confidence in the process and the outcomes. Driving client confidence reduces behavioral mistakes and improves retention and referrals.
The old norm of a risk tolerance assessment purely as a “check-list” compliance item is outdated. A fiduciary-caliber risk-assessment tool will develop and maintain business as well as strengthen compliance.
Mark Friedenthal is founder and CEO of Tolerisk, a cloud-based SAAS tool for financial advisors to provide better risk tolerance assessments for their clients.
1 The S&P500 declined 33.92% from 2/19/20 to 3/23/20 – Source: Bloomberg
Read more articles by Mark Friedenthal