Risk tolerance is related to the amount of assets a client holds as well as their investment horizon. It also involves how clients manage fearfulness. Given all these details, a risk tolerance assessment can seem firm or concrete. It isn’t.
An essential part of investment planning has always included drafting a strategy to account for a client’s level of risk tolerance. Yet, assessing risk tolerance has always been balanced on two imprecise supports. The method of assessing risk tolerance is subjective, it requires self-awareness by a client. It is also usually a snapshot based on a client’s current life situation. Advisors may want to consider whether their clients who are considering drastic changes (usually thought of as emotional investing) are reacting to a volatile market or if one of the imprecise supports of risk tolerance measurement has slipped.
Advisors use risk tolerance, how clients react to uncertain times and information, to create effective long term plans and on investment strategies. Current market instability can offer a time for reassessment of risk tolerance. Clients may want to believe they can tolerate more risk than is actually true if they haven’t encountered a level of volatility before. Yet, volatility is nothing new. In fact, it may be the new normal for regular investors. If that were true, then investors would be less likely to have an emotional reaction to volatility. However, many investors are pushing advisors to make substantial changes.
Emotional investing can cause short and long term damage to an investing strategy. It often ignores other aspects of investing such as tax implications, flexibility, cost of administration and focuses only on returns. Moving assets too often can ding investors with transaction fees, decreasing the amount they could be earning. Nor should investors stick their money in an account and never re-assess. That kind of investing isn’t un-emotional investing, it’s poor planning.
A strong investment strategy often starts with risk tolerance as an underlying aspect, along with unique assets and specific needs. Risk tolerance is sometimes assessed by looking at an individual’s beliefs about risk through four factors: propensity, attitude, capacity, and knowledge. Risk tolerance groups are often classified as aggressive, moderate, or balanced and conservative. Risk tolerance is related to the amount of assets a client holds as well as their investment horizon. It also involves how clients manage fearfulness. Given all these details, a risk tolerance assessment can seem firm or concrete. It isn’t.
Investors aren’t always the best judges of their risk tolerance. Many advisors say that their clients identify having a higher risk tolerance when the market is doing well, but when the market falls so too does their client’s risk tolerance.
Investors with a longer time horizon can manage more risk, usually related to chronological age. That means risk tolerance can change over time. It can be changed by loss of a job, a health crisis, saving for family education. Investors who tolerated volatility in the market during the pandemic might not be able to do so if other factors have changed, for example, their health status has changed. Investors may not have the self-awareness to know how a life event has altered their risk tolerance. Yet, when that changes, investment strategies may need to be altered. This is why the current volatile market can help identify clients who may need to make some strategic changes.
Financial advisors can help identify common major life changes a client may experience, such as housing, education, or health. But they can’t identify those life changes without information from the client. Advisors can use the current volatility to prompt conversations with clients, as a way to help them recalibrate not specific investments but long term investment strategy.
These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.
Before leaping into the unknown, we recommend a thorough examination of your plan. Because we are experts in the field, we know the marketplace and know what your existing vendor is capable of offering. Through this examination, we can help you optimize the service you receive.
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