The first time I placed a $10,000,000 bond trade, I was understandably nervous. I told my mom about it afterwards because it went well and I was proud of myself. She said, “Your job terrifies me.” I laughed. My parents were both research chemists. Mom had told me previously that, when she pours one thing into another which could explode, she would put her other arm behind her back, so if it did explode, she wouldn’t lose both hands. She said this very calmly and matter-of-factly. (No, I was not helping her in the laboratory. I think she was explaining why she is so good at not spilling in the kitchen.)
Had I botched this bond trade, I would have had to place a trade error correction, which would have cost my employer the difference between the trade I should have made and the trade I did make. If it was really bad, we might have had to use our Errors and Omissions Insurance, and I might have gotten fired. (I did not botch the trade. I did irritate the bond trader by making him repeat the details back to me twice.) In no way would this have resulted in the loss of any actual limbs.
My mom and I have very different risk tolerances. But we were taking very different risks, too. I was risking a percentage of a large amount of money which I knew was protected by various mechanisms against me screwing it up too badly. Mom was arguably risking bodily harm, but because she knew what she was doing, she perceived the risk as negligible. Neither of us would be willing to take on the risk that the other found perfectly commonplace.
What Is Investment Risk?
When we talk about risk in investments, we mean volatility of returns. U.S. large-cap stocks have on average returned 7-10% annually over medium-term periods for decades now[1]. But sometimes, they have “returned” negative 30% very quickly. Holding one’s wealth in cash is comparatively “safe,” in that the risk of nominal loss is essentially zero. The cost, though, is that the returns are similarly low, and over time, the spending power of the wealth is eroded by inflation. To reach a point of financial independence, it’s necessary for most people to take some investment risk to grow their wealth .
There is no free lunch in investing – the higher potential return investments all have higher volatility. I could go on a rant about people selling investment snake oil here, but suffice to say, when there are “twenty dollar bills lying on the sidewalk” in investments, markets move fairly quickly to reflect that in the price of the relevant securities, and we return to the normal scheme of things, where you can’t have the upside without the downside.[2] We all have to take some risk.
The “Risk Tolerance” investment advisors seek to measure is the ability to stomach fluctuations in securities markets. So in order to choose an appropriate investment strategy for a client, we need to know how much risk they can afford to take and how much risk they can tolerate.
Willingness vs. Ability to Take Risk
These are two very different things. One could have a hundred dollars to their name and put it all on double zero on a roulette wheel. They can’t really afford that risk but they are eager to take it. Another investor might have ten million dollars in short term CDs earning half a percent (if they’re lucky) in interest. This person can afford to take investment risk but perhaps doesn’t want to. We try to measure both separately – willingness to take risk and ability to take risk – and address each in turn.
Lots of factors affect willingness to take risk. Clients may be unfamiliar with investing and very wary of what seem like complicated decisions. Or they may be very experienced with investing but stinging from unpleasant experiences in prior down markets or with advisors who tried to “time the markets” – guessing when to pull money out and put it back in – and failed.
Alternately, they may love investing, be totally comfortable with it, and eager to jump on new opportunities as they hear about them. Clients may watch their account values daily and feel anxious when markets move unfavorably. Or they may never look at them and be genuinely surprised to see what’s in there when they get a year-end summary from their 401k program.
Beyond familiarity and experience with investing, general personality traits also affect investment risk tolerance. These might include anxiousness, adventurousness, FOMO, hating math or the unfamiliar; there are many factors that could make an investor more or less comfortable with investment risk.
Lastly, how a client feels about money in general will also be reflected in their investment risk tolerance. Are they nervous about having enough? Do they feel like money just works itself out? Or expect to have to watch every dime like a hawk?
Ability to take risk includes how much money a client has to invest, how soon they will need it, and whether they have the funds or income they need to run their life in the meantime. We can help improve a client’s ability to take risk by working together to increase savings, reduce risk elsewhere (suggesting a life insurance policy for example), reduce debt, and generally striving to improve the household balance sheet.
Risk Tolerance Over Time
Risk tolerance can change, too. Sometimes we find that clients can tolerate more risk if they stop watching their accounts every day. Or it might help to think of the goals associated with different accounts – if a 45 year-old plans to retire at 65, their IRA and other retirement accounts have a longer time horizon than, perhaps, the 529 plan where they are saving for their teenager’s education.
We can demonstrate that they have longer to recover from an unfavorable market in the former account and encourage them to accept more risk there in order to gain the possibility of higher returns. Even knowing someone else is monitoring the investments can help people feel more at ease with investment risk.
Conclusion
Ultimately, we are constrained by the client’s wishes. We will not allocate a client’s investments more aggressively than they have given permission to do. But by discussing concerns, demonstrating past performance (which does not guarantee future results), and taking on the daily work of investment management, we hope to free clients to invest strategically for their financial plan’s success, and spend their time and energy on other pursuits… like not blowing up the lab. We are here to help.
[1] As measured by the S&P 500
[2] Enter an options strategist to tell you about their beautiful costless collar program! Reduce the volatility at no cost to you! Nope. You have to give up much of the upside to pay for the possibility of avoiding some of the downside. Plus you probably get to pay commissions along the way.
She lives in Portland, Oregon and serves clients nationwide.
- Monthly Economic Update - May 13, 2021
- What is Risk Tolerance? - April 23, 2021
- Monthly Economic Update - March 11, 2021
