Two popular trends in the investment business may be affecting the financial health of clients. In my opinion the use of “risk tolerance assessment” tools, combined with the trend toward model portfolios, may be good for advisors and bad for the customer.
Many advisors use risk tolerance assessments. The issue is that when markets are lovely and rising, these tests have the potential to show that risk tolerance is high based on the client’s response. When markets are ugly and falling, they have the potential to show risk tolerance is low based on the client’s response. These tests measure changing conditions, not some fixed internal thermostat.
The potential for mischief comes into play when the results are tied to model portfolios. A lower risk tolerance potentially gets you a portfolio with less chance for long term growth, lower exposure to fluctuating but rewarding markets, and more supposedly stable investments with smaller potential returns. So the market goes down, risk tolerance goes down, and people may sell out at low points.
Conversely, when markets go up, risk tolerance goes up, and people may buy in at high points.
The old rule is ‘buy low, sell high.’ It is my opinion that the supposedly scientific approach of risk tolerance assessment tied to model portfolios encourages people to do exactly the opposite.
It appears to be objective, almost scientific. The pie charts are impressive. But the process panders to the worst elements of untrained human nature—and actual investment outcomes may show it.
It is as if the cardiologist, upon learning that a patient dislikes sweating, prescribes sitting on the couch instead of exercise. Or if a pediatrician first assesses a child’s tolerance for icky-tasting medicine, then tailors his prescription accordingly.
We believe that people can handle the truth. Our experience says people can learn to understand and live with volatility on some fraction of their wealth in order to strive for long term returns.
So the first step in our process is to determine if a prospective client can be an effective investor. It doesn’t matter to us whether they were born with great instincts or are trainable—we provide support and education through all kinds of markets. It takes a lot of effort, but we do it because of the results it may provide.
If you need a refresher on the ‘buy low, sell high’ thing or would like to discuss how this affects your plans and planning, please write or call.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The purchase of certain securities may be required to effect some of the strategies. Investing involves risks including possible loss of principal.