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Risk Tolerance vs Risk Preference Thumbnail

Risk Tolerance vs Risk Preference

Investment Management

Should an investor allocate portfolio risk by their tested risk tolerance or by their preferred risk decision?

What does a risk tolerance survey do for the client and the advisor?

Attempting to assess your Risk Tolerance protects the advisor from potential legal and regulatory liability. It is used to help you select how to allocate your portfolio; if your tolerance for risk is high, then you may end up with a suggestion of allocating 80% of your portfolio to Equity-type investments and 20% to Cash and Fixed-income-type of investments. If your tolerance for risk is low, then the inverse is likely to be the suggested allocation.

There are flaws in the risk assessment process:

Chief among these flaws is the risk tolerance of most investment advisors is significantly higher than that of their average client. This leads to a pervasive predisposition of an advisor to build too much risk into a client portfolio. Therefore, taking a valid assessment survey, independent of the advisor, is vital.

Another  major  flaw  lies  in  the  creation  of  risk assessment tools themselves. Most so-called risk assessment tools or questionnaires are nothing more than 10-25 questions cobbled together by the organization dispensing investment advice. When one peals the onion back, most assessment surveys may meet regulatory standards, but they have no documented, psychometrically valid (scientifically tested and monitored) underpinning.

Should assessed tolerance for risk perfectly align with the actual risk in all client portfolios? 

No. Story Capital feels that allocating the portfolio merely by the assessed risk tolerance is an incomplete, inaccurate, and potentially misleading process. Here’s why:

  • Most people feel a greater sense of pain during portfolio losses than they feel wellbeing for the same percentage of upside gain; therefore, not until a client experiences an extreme negative market move like 2008 (-38.49%), do they make the real-world connection between portfolio allocation and actual portfolio risk. Watching your portfolio disintegrate is a painful way to make the real-world connection.
  • Second, most advisors focus on portfolio allocation as though it is a snapshot or one-time activity. Assessing portfolio risk should be viewed in a comprehensive cash flow model showing how resources  pour  into  and  out  of  the  portfolio over time.
  • Third, most portfolio allocation discussions occur in a complete income tax vacuum with no focus on what percent of funds are held in taxable, tax-free, or tax-deferred accounts.
  • Fourth,  with  the  exquisite  financial  modeling tools  available  today,  a  capable  advisor can  create  a  tax-adjusted,  cash  flow  model that  reflects any one or all of the following risk scenario assumptions:
    • Assume  the  underlying  investments  in  the financial  model  exhibit  the  volatility  and historic performance that may have existed over a rolling, historic 25-year period for each asset class represented in the actual portfolio.
    • Assume  a  conservative  average  annual compound rate of return for various buckets of money in the portfolio like 6% for Equity- type investments, 4% for Fixed-Income-type investments, and 2% for cash.
    • Assume a 0% rate of return on all investments in the portfolio and then review the model to see if there are sufficient resources to carry a couple to life expectancy at their desired lifestyle. Many clients find this analysis to be highly informative.

Independently reviewing each of the above assumptions provides our clients with empowering context to decide what their “Preferred” risk allocation might be. Once educated, approximately 60% of the time, a client’s preferred risk allocation is not equal to their tested risk tolerance. Here are Story Capital’s, real-world behavioral results, which stem from constructing detailed cashflow models with hundreds of clients over 18 years reflecting the above assumptions:

  • Not one client has ever allocated to a no-growth portfolio though a high percentage of our clients have a successful life outcome with a zero percent return assumption in the portfolio.
  • About 40% of clients end up allocating to the risk tolerance suggested in their risk survey.
  • Stunningly, about 50% of clients, will end up allocating to a more conservative level of risk than their risk tolerance survey otherwise advises. (abhorring loss is real—so is sleeping well).
  • Approximately 10% of clients are resolved to allocating beyond their tested risk tolerance primarily because these clients have unique situations such as:
    • A portfolio highly concentrated in one security or they own a privately held business
    • They  own  annuities  which  safeguarded  their  retirement  cashflow  by  eliminating  longevity, inflation,  and  investment  risk;  thereby  allowing  a  much  larger  portion  of  their  portfolio  to  be allocated to all-out growth to create more resources for children or charity.
    • They  participate  in  a  Defined  Benefit  Pension  Plan  that  acts  similar  to  an  annuity  in  that  the pension is impervious to investment and longevity risk.

In summary, here are the vital takeaways:

  1. It is vital to take a psychometrically valid risk assessment survey independent of the advisor.
  2. It is vital to build a tax-adjusted, cashflow-based financial model that extends to or beyond your life expectancy.
  3. It is vital to learn the historic maximum negative return, over at least the past 25 years, so one can link real-world, downside portfolio risk to a specific portfolio allocation.
  4. It is vital to learn the minimum portfolio return needed to sustain your cash flow needs to life expectancy. If an advisor will lead a client through the above vital discovery steps, then the client becomes empowered to select their “Preferred” risk tolerance. Anything less is insufficient or worse, potentially damaging to one’s financial and emotional well-being.

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