You’ve probably heard the term “risk tolerance,” which is a common and important concept in investing and retirement planning. The idea is that every investor has a certain level of tolerance for risk. When a person is “risk averse” it simply means that he or she prefers lower risk than higher risk. This basic premise in the investment world is wrong… OK, maybe wrong is too strong of a word, but it depends on how we define the term risk.
We use a risk tolerence questionaire, which was developed by FinaMetrica. The third question on the profile is:
When you think of the word “risk” in a financial context, which of the following words comes to mind first?
In finance I was trained to think about risk as volatility or standard deviation or, said another way, how much an investment moves up and down over time. My answer to the question above would be 2. Uncertainty. However, when the average investor thinks about risk, the answer that comes to mind isn’t even on the list. It’s usually a simple four letter word that no investor likes: Loss.
I think it is far more accurate to say that investors are “loss averse” rather than “risk averse.” Most of us don’t mind when our investments move higher or even higher than we expect. I’ve never said, “I’m terribly sorry, but your account was up way too much last year. We did something wrong here.” Investors don’t like losses… I know this isn’t exactly earth-shattering news, but as advisors we try to understand how loss averse our clients are and generate the best returns we can based on that constraint.
Research into loss aversion shows that for most investors, losses have a bigger emotional impact than gains. This graph is from a paper by Daniel Kahneman who won the Nobel prize for his work in behavioral economics. Think of “Value” on the graph as how happy you are about an investment outcome. The more you make, the happier you are. However, it isn’t in a straight line.
The important question to ask in retirement planning regarding risk is what level of losses can you sustain and still stick with the plan? As illustrated by the red arrow in the graph above, at some point you are so unhappy that you abandon your financial plan and look for other options.
But where is that point? That question isn’t always easy to answer. Even after we answer it, there may be an issue with designing an investment solution that satisfies your loss aversion and still reaches your retirement goals.
We use FinaMetrica, which is an Australian company that developed a psychometric risk tolerance questionnaire. I found the software a few years ago when we were trying to identify the best risk tolerance questionnaire in the market. This software acts as a starting point. Once our clients complete their FinaMetrica profiles, we talk about the kind of strategies that might be a good fit. We then ask clients how they would feel about different levels of losses and how they would expect their accounts to react to a 20 percent increase or decrease in the stock market.
The biggest danger in setting a level of risk is that retirees always seem to want more risk when markets are doing well and less when they are doing poorly. It’s just human nature. When markets go up we want to buy and when markets go down we want to sell. Buying high and selling low is not a sustainable strategy.
Bottom Line: Risk is a complicated topic and something that should be discussed and readdressed on an ongoing basis. It’s a vital piece of the retirement planning puzzle, not just a single number on a spreadsheet.
From the desk of Kris CarrollRisk