Investor's column: Examining the risk tolerance of you and your financial advisor
A financial advisor is required to know his/her client including their tolerance for taking risks.
This information is a universal requirement of all financial firms and is constantly reviewed by regulators in our country.
It’s your life and your money, but how can an advisor really know your attitude of what risk you can accept unless they get to know you and you let them know how you feel you would handle market fluctuations.
A study completed several years ago by a financial planning software company indicated that up to 83 percent of their market (investment firms) provided clients with questions and illustrations that were unable to accurately assess risk.
Risk has multiple dimensions. One side is just your willingness to take risk or have aversion to risk. Another side is your capacity to endure financial loss.
For example, if you are on a fixed income, based on your investments, you would be interested in low market risk investments. Risk perception is the final dimension.
Imagine that an investor was a risk taker with his/her investments, but they became convinced by a YouTube video that is selling a book that says that we are in a bubble and the big crash is happening, he/she may become detached from reality and decide to sell everything because the market was going to go to zero.
Our job as a financial advisor is to always review a clients’ tolerance and discuss their capacity and perceptions of what real risk is in their portfolio.
Recently I was reviewing a portfolio built by another financial advisor. My client was expressing a high level of dissatisfaction with his account. As we were reviewing it, I realized that the client’s risk tolerance was higher than the conservative allocation of his portfolio.
Could it be that their former advisor incorrectly assessed his risk or was the risk assessed correctly, but the advisor was more interested in never enduring a moment that might be uncomfortable with the client when their account had dropped in value, as investments sometimes do?
The lower rate of return could make a major difference in the clients’ ability to maintain their current lifestyle in retirement. I call it the silent killer.
Lower performance gets missed, especially when you are not realizing that your gain could have been 2 percent more, which then never compounds, and the entire trajectory of your portfolio becomes lower.
Fear is a dangerous thing, especially when we are gun shy from a previous experience. It’s common to find a parent that over-protects a child from potential risks that occurred to them. We base our decisions on past experiences, we do that because we are human.
Most of the time we hear the opposite from clients. A client will leave an advisor because the advisor took on too much risk and did not accurately match a client’s risk tolerance and they ended up losing a large amount of money.
For example, a client who transferred their accounts to my firm showed me losses in one holding in their portfolio of approximately 40 percent. The investment was with a respected company, but that type of investment has an added layer of risk that is unknown to most clients and even some advisors.
Risk aversion can be just as problematic in a portfolio as risk taking. A clear understanding of potential financial outcomes is the most important factor in being able to gauge market fluctuations which then can be matched with a tolerance level.
Danny Wood is an independent financial advisor with Shoreline Financial Partners in Bradenton. To learn more visit shorelinefinancialpartners.com.