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Millions of Americans are unprepared for retirement because of risk intolerance. There are other reasons, too, of course, but I’ll suggest that low-risk investing is a huge one! Risk intolerance has a massive societal cost.
I once read a book where economist (and actor) Ben Stein labeled “risk tolerance” as “institutionalized malpractice.” Before you get excited, let me explain what I think he meant and why it is important.
The idea behind risk tolerance is that each person has a different ability to withstand portfolio volatility. Based on that personal ability, the perfect portfolio would be one that maximizes performance without exceeding the personal volatility limit. Based on that ability, there’s no point in pursuing a more aggressive portfolio posture because the client would suffer too much as prices rise and fall.
My experience (not formal research) suggests that most people are naturally risk-averse. Their risk tolerance starts low and rises as one ages, with experience, education, cultural norms, and success. It also cycles up or down with specific circumstances, the economic climate, and a variety of other factors. But – generally – people prefer less risk over more risk.
This creates a professional dilemma. Risk-free investments aren’t adequate to meet most people’s financial goals. Simply, a lot of people don’t earn enough to accumulate enough for their retirement needs. Retirement years can easily last as long as working years.
For many people, setting money aside each month is insufficient
Funding a reasonable retirement requires riskier assets, compounding over several decades. Nearly everyone’s preference would be less-risky investments (risk intolerance); everyone’s need is for more-risky investments (risk tolerance).
I know all that, but I’m uneasy with the implications. One major implication is that millions of people are destined to fail (as measured by their ability to fund a decent retirement) because they can’t withstand portfolio volatility! It’s built-in excuse to fail.
How would you respond to these statements: “Sure, I understand insurance, but I can’t afford to insure my car.” “I’d like to quit smoking, but I just can’t stop.” “I don’t like safety belts, so I know my children don’t like car seats, either.”
Seriously.
How are those different than statements like this: “When I retire, I’ll need to have some extra money set aside, but I just can’t stand any risk. I keep all my money in the bank.” It is the same argument, but money is a very different measure. And this is the powerfully important point: What is the personal and family cost for tolerating that apprehension? It means failure to achieve what you need for retirement.
One challenge that advisors face is how to push clients towards the portfolio they need instead of the one they want. It’s a fine line between a losing portfolio that’s too comfortable and a winning one that is too uncomfortable. All advisors who work with investments have had to balance risk and comfort before.
The national issue is bigger
If any of this sounds familiar to you, what needs to be done? Are there steps people can take to become more risk tolerant? Here are a few initial ideas. Obviously, societal issues take larger solutions.
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Teach more. Most studies on this subject suggest that risk tolerance rises as people learn more about investing. Recommend a good book or some articles on investment basics. Investing isn’t hard but understanding four or five solid principles is enough to help.
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Start small and build experience. Similarly, people tend to become more risk tolerant with their investment experience. Stock market cycles can be scary at first, but they become easier after you’ve survived one or two. If you start with smaller amounts, the first cycles won’t seem so bad, either.
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Suggest separate wallets. Set up portfolios for different purposes. Money being saved for a new car shouldn’t be mixed with money for the kids’ college. A retirement account should be separate, too. This can help because the longer-term money (retirement accounts) feels less urgent than the car money, allowing you a bit more comfort and tolerance.
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Reduce investment noise. The media – especially the financial news sources – benefit from drama. This is entertainment first, and education second. Every story feels important because anxiety is a key part of drama (horror movies, anyone?). If you are already nervous, this is a recipe for failure.
Investing isn’t an advanced science, and almost anyone can learn enough to succeed. But a natural risk intolerance is a huge impediment to funding a successful retirement. As caring advisors and future retirees ourselves, we need to fight back. No one – lawmakers, regulators, academics, or journalists – knows or cares more about retirement security.
Dan Danford, CFP® is a NAPFA member in Kansas City, Missouri. He learned early ideas about money from his late father Thad Danford who charged rent on the family lawn mower while Dan cut neighborhood lawns. Danford is a practicing investment advisor and author of HAPPY TO BE DIFFERENT: Personal and Money Success Through Better Thinking.
Read more articles by Dan Danford
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
