Risk Tolerance is one of the most obscure topics in finance. It’s extremely personal and difficult to measure.
Our industry invests a lot of time, money, and resources to determine your personal risk tolerance. Why? Because the optimal investment plan (portfolio) is the one that you can actually stick with, not the plan that pencils best in a textbook equation. If it does not suit your sensibilities, whatever they may be, you won’t possess the discipline to see it through to your desired goals.
Historically, times of calamity have led investors to abandon their plan, which is why the finance industry seeks this clarity around your investing tolerance levels.
The X Factor
There is a variable in this risk tolerance discussion that I’d never considered in the past – Me. As your advisor, what impact can I have on your risk tolerance? Here’s my hypothesis: An advisor’s presence can greatly influence an investor’s risk tolerance, their willingness to endure volatility.
Note, I’m using the word “risk” synonymously with volatility because that is the standard measurement agreed upon and most widely used in finance. Some semantics here are worth unpacking in another discussion, but for today, we will agree to use risk and volatility interchangeably.
A Universal Truth
To test my hypothesis, let’s look for examples outside of finance that would contribute to this theory – the idea that the risk tolerance of the “guided” would vary based on the presence of a guide. This would mean that this tolerance level is not solely personal, but environmental too – nature and nurture.
Sky Diving and Safaris
To do this, we need to first start by brainstorming some risky activities. How about sky diving and safaris? Those seem like pretty risky activities. We will juxtapose the risks of sky diving and safaris to that of investing.
In investing, there is a population of do-it-yourselfers (DIYers). Investors that choose to do the planning, portfolio construction, and day-to-day management all on their own. Now, the “risk” we are talking about here is not life-or-death, but rather a risk of one’s financial well-being; oversimplifying, we could imagine a fork in the road, one path leading to financial ruin and the other to prosperity. I know, I know, it really isn’t that binary, but stick with me.
For skydivers and safari enthusiasts, I’m guessing there are a lot fewer DIYers – there is a population of professionals and a population of those interested in being guided. Here, we do see the risks as life-or-death. A mishap while falling through the sky or coming across a hungry lion leads to literal ruin. The risk here is real, measurable, palpable, and scary.
How does one go about enduring this type of risk? How could you ever tolerate sky diving or safaris? It’s actually quite simple; one shifts their confidence from their own expertise to the guide’s expertise. This reliance on those who “know better” is not only premeditated but is innate within us all. When we instinctually know we are headed down a potentially dangerous path, we seek help and guidance from someone more experienced than us. Someone we can TRUST.
So… can this same truth apply to investors resourcing an advisor? Can the guided expand their tolerance for risk (volatility) based on their confidence/trust in their guide? Yes, I believe so. The advice-givers competency, expertise, and experience can (and should, to an appropriate degree) influence a client’s risk tolerance.
The Road to Freedom
Why does this specific timing of advice matter? Well, if we believe that risk and reward have a relationship, then incremental increases of one’s tolerance should, to some measure, incrementally impact their returns, which would mean this matters a lot.
Last week we talked about the power of compounding and the GINORMOUS impact a marginal increase in returns can have over long time periods. It is this compounding process that leads an investor to financial freedom.
Now, if your rebuttal were that maximizing returns should not be the sole focus of a plan, I would agree with you 100%. BUT good stewardship and solid returns over a lifetime can produce incredible wealth. Wealth to support the things you love and care about – your family, the charities that are near and dear to you, freedom and flexibility with your time, and the list goes on.
Did we possibly stumble upon a key variable that most investors and advisors don’t consider? Is this presence of an advisor to help extend an investors tolerance the hidden gem of value? Perhaps.
One might reference studies like the Vanguard Advisor’s Alpha white paper, which credits a large portion of a financial advisor’s value to “Behavioral Coaching.” This being the idea that the advisor assists an investor in making good behavioral decisions. These “behaviors” are often those influenced by fear or greed, and the “coaching” is relative to guiding an investor on how to react. My hypothesis is centered on the proactive, getting the tolerance measurement right before creating the portfolio and the plan. This difference – proactive vs. reactive – makes these two concepts very different in both implementation and impact.
Leap of Faith
Where is this all coming from? Simply put, my hypothesis stems from my insatiable appetite to create a better client experience. My dream advisor/client relationship is one void of surprises and abundant clarity around what one should expect. I do not mean the surprises of the world – pandemics, terrorism, recessions – but rather the realities of how a plan and portfolio operate and reasonable expectations around how investments will behave.
My conclusion is that healthy dialogue between a client and advisor, accompanied by a methodical discovery process, is needed to determine risk tolerance levels accurately. A competent advisor, one worthy of being trusted, can and will influence a client’s willingness to endure but must do so with skill and only in the best interest of the investor. Trust and clarity between the advisor and client remains a foundational building block to creating significant wealth.
Not an advocation to throw caution to the wind, nor an encouragement to have blind faith, or even a refuting the tenants of diversification, but rather proof that your willingness to jump out of a plane or to photograph a Tiger in the wild, all depends on who you’ve anchored yourself to.
Have you and your financial guide discussed your risk tolerance lately?