© 2016 Bloomberg Finance LP
For decades, investors have been told to assess their “risk tolerance.” While this may be relevant in some circumstances, it’s less important than long-term return for retirement savers.
The danger of overemphasizing “risk” represents a financial literacy hurdle that only consistently applied education can overcome. Worse, you may be unknowingly subjecting yourself to this popular metric. And it may be placing your retirement in peril.
The idea of “risk” became important more than a half century ago when academics formulated its relationship with return. They determined the greater risk you take, the greater reward you could expect. Otherwise, why take the risk?
Of course, it took several decades for this seed to germinate before it blossomed into the term known as “risk tolerance.” In doing so, the concept jumped from the scholastic world to the realm of marketing. It turned out, if framed properly, the pursuit of risk tolerance could make selling financial products much easier.
“Many years ago,” says Sean Lannan, Managing Director at Morgan Stanley
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based in Chicago, “advisors needed some broad measure of how much volatility an investor could sustain and ‘risk tolerance’ became the prolific name for that measurement.”
By using Cosmopolitan-type personality questionnaires, you not only felt like you discovered something about yourself, but you became convinced your answers led directly to an implementable investment plan. It quickly became a habit too difficult to break.
But was it all your fault?
“Risk Tolerance was a term coined to help shift decision making capacity back to the client,” says Brian Halbert, VP Retirement Services at Pensionmark in Austin, Texas. “Its goal was to take pre-qualified questions and assume the lifecycle of an investor was linear. I don’t feel as if investors got hooked but rather were kept on a hook due to lack of enhancements in the due diligence process.”
Still, if it only reinforced what you already believed, the ability of a sophisticated test to guide you sounded comforting. Who wouldn’t be attracted to this?
“Risk tolerance is typically measured by completing a short quiz,” says John Madison, Financial Counselor at Dayspring Financial Ministry in Ashland, Virginia. “Many investors like them as it provides what they think is actionable advice.”
Oddly enough, as risk tolerance questionnaires grew more complex, the end result remained strikingly similar.
Kyle Westhaver, Financial Advisor at Nicola Wealth in Toronto, Ontario, Canada, says, “Unfortunately, many investors first consider their ‘risk tolerance’ when completing a questionnaire that aims to quantify their willingness to take on ‘risk,’ but, ultimately, how much of their investments are allocated to either stocks and bonds? This is terribly simplistic.”
Just like any addiction, you can’t break it if the infrastructure is built to encourage you to continue its use.
“Investors have been hooked on risk tolerance partially because of the financial services industry,” says Ken Van Leeuwen, Managing Director & Founder of Van Leeuwen & Company located in Princeton, New Jersey. “That is one metric that is always on our new account paperwork and is rarely understood by clients without further explanation.”
From a marketing standpoint, the questionnaire itself was a brilliant tool. Good marketing emphasizes the sizzle, and nothing sizzles more than something that focuses on you. If it’s all about you, it often doesn’t matter what the product is.
“People, investors or not, love to learn about themselves through surveys and questionnaires,” says Ryan McPherson, Director of Coaching and Advising at SmartPath in Atlanta. “Risk tolerance is no different. Many investors complete risk tolerance questionnaires to gain insight on how they should be invested.”
By concentrating on you, the pitch becomes captivating. It’s easy to forget what you really should be concentrating on. That could hurt you. And you might not even realize it.
The problem arises because it’s too easy to think only of the downside. Loss aversion is a common behavior that consumes many.
“Many investors may not understand the volatility that comes with riskier portfolios,” says Madison. “The long-term returns can be great, but the short-term roller coaster can be hard for many investors to stomach.”
There’s nothing wrong with mitigating risk. Until there is. And then it may be too late to do anything about it.
“If you focus only on reducing risk,” says Jennifer Ellison of BOS, a wealth management firm in San Francisco, “you may end up with a portfolio that is far too conservative to meet your long-term goals.”
This last point cannot be understated. The process of gauging your tolerance to risk appears very well formulated. It looks like an exact science. That’s what makes it so alluring… and so hazardous.
“Risk t0lerance assumes a geometric, constant internal rate of return over the stated period. This NEVER happens,” says Dr. Guy Baker, Founder of Wealth Teams Alliance in Irvine, California. “Markets go up and markets go down. Risk tolerance is an indication of how to manage the investor more than how to invest the funds. The problem with risk tolerance is that it might not take into consideration the goals.”
For retirement investors with a long-term time frame, your risk tolerance is very nearly irrelevant. “When your time horizon is long, risk tolerance is much less important than when your time horizon is short,” says Robert R. Johnson, PhD, CFA, CAIA, Professor of Finance, Heider College of Business, Creighton University in Omaha. “‘Time in the market is more important than timing the markets’ is really a universal truth.”
This is where being hooked on risk tolerance can harm you. If you’re far away from retirement, time tends to mitigate the downside and amplify the upside. If you allow your fears (a.k.a., “risk tolerance”) to drive your decisions, you may find yourself living a very uncomfortable retirement.
“Risk tolerance can be dangerous when investors with multi decade timeframes overweight their portfolios to cash and bonds after receiving conservative risk tolerance results, usually without much context,” says McPherson. “These overly conservative allocations depress investors’ likelihoods of meeting or beating inflation over time.”
Even as you’re nearing retirement, undue emphasis on risk can lead you astray.
“When you only consider timelines vs. emotions in risk tolerance, so many things can go awry,” says Jordan Fandry, Financial Advisor at Manske Wealth Management in Houston. “Circumstances such as, someone retiring in 5 years with a high tolerance for risk could make a move that sets their retirement back by a decade. On the other hand, someone with an incredibly low risk tolerance that is retiring in 5 years might not be able to stomach the investments that would otherwise provide growth and income in retirement, which also negatively impacts their investment goals.”
More critically, you are not an unmoving statue. You are a living and breathing human being. Your life, like the market, ebbs and flows. Any test is nothing more than a snapshot in time. And a snapshot in time only matters in that moment.
“A person’s risk tolerance should be dynamic and not static,” says Adam Taback, Chief Investment Officer for Wells Fargo Private Bank in Charlotte. “‘Risk tolerance’ is a very imperfect question to be used in assessing how to manage your portfolio simply because your risk tolerance tends to not be a static state and needs to be revisited constantly.”
What should you pay more heed to?
Taback says, “Your age, income, goals, emotions, time horizon and need to be prepared for the unexpected all play a role in setting a risk tolerance. This is particularly challenging since, if you are like many others, you tend to be more willing to take risks when markets are going up and less willing when they are falling. You have to balance your: (1) ability to take risk (what you can afford), with; (2) your willingness to take risk (what your nerves can tolerate); and, (3) your objectives/needs (in achieving your financial goals). All three of these will rise and fall in importance based on the moment in time.”
And time is perhaps the most critical component of all.