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By John Steiven, Sr., CFA, CFP®
If someone asks about your risk tolerance, what exactly are they asking? There is a wide range of acceptable answers—some of which are more startling that others.
Yet, no matter what your individual risk tolerance might be, as investment professionals we meet the needs and objectives of our clients no matter where they fall on the scale.
Investing is, and will always be, a balancing act between “eating well” and “sleeping well”. For our clients to reach their goals and objectives with their funds, especially if they are a bit late to the game in investing, may cause them take on more risk (normally defined as additional equity exposure) to “eat well”.
Why is this?
Equities have a higher expected return and so it is easier for them to reach the aspirational amount they desire. While “normal”, equities tend to be more volatile in the short term, and investors have to be compensated for this “bumpy ride”.
Clients who do this may not count on the sleepless nights along the way as their portfolio feels like they are riding a rollercoaster as equities really do experience that expected volatility. The problem is, these sleepless nights occur when the market is at its “scariest” (think dot-com bubble, housing bubble, COVID breakout, etc.). The exciting part is when our “fight or flight” defense mechanism kicks in—a client might give us a call, wanting to go to “cash” at the worst possible time.
For example, someone who sold on March 23, 2020, the bottom of the COVID crisis when it appeared like we were going to replay the Great Influenza of 1918, has seen their cash holdings hardly move (yet they were sleeping well) while equities since then have more than doubled.
I am a firm believer that clients should take on only enough
risk to meet their goals and objectives. We do not let expected returns define their risk tolerance, we talk with them to bring awareness to the fact that a decision must be made to accept the returns their risk tolerance dictates. If this means they need to save more, work longer, or spend less in retirement to reach their goals, then so be it.
Investment research shows a diversified approach oftentimes yields a more comfortable ride and if we can keep investors comfortable, we can keep them investing. Perhaps if their sleep is more peaceful, they can keep invested— thereby improving the chances they successfully accomplish their long-term retirement goals. That is a “win” in my book!
The next time someone brings up the topic of “risk tolerance”, don’t be alarmed. You can confidently help guide the discussion and be a trusted resource.