Are You Being Honest About Your Risk Tolerance?

In the hit TV show House, lead character Dr. Gregory House is infamous for saying never ask patients how they are feeling because they always lie. Better to just judge their symptoms. Unfortunately the same can be said for investors’ tolerance for risk.

In order to recommend an ideal asset allocation for our clients, we ask a series of questions to determine their investment goals and risk tolerance. The vast majority responds that they want moderate risk and moderate returns. However, almost every client ignores our recommendations when presented with moderate risk managers (only 80% of the S&P 500’s risk) because the amount by which they outperformed the market (2% per year over a long period of time) doesn’t seem all that sexy. A 2% premium doesn’t seem significant if one can’t visualize risk. This also leads us to believe investors don’t understand the value of compounding.

If I could own an asset that has 80% of the risk of the market, but is likely to earn 2% more than the market per year, then I would make that investment 11 times out of 10. To illustrate the point, if I’m 40 years old, save $10,000 each year until I retire at age 70 and am able to invest all my savings in instruments that return 9% per year (the approximate average return of the S&P 500 over the past 30 years), then I will end up with $1.36 million upon my retirement. If I could increase my rate of return by just 2% per year then my savings at retirement would grow by approximately $630,000! In other words, a 2% increase in returns would lead to a 50% increase in my nest egg. That could make a huge difference in my lifestyle and peace of mind. What might seem like a small increase in return, through compounding, can make an enormous difference over time.

It’s not surprising that investors want to have their cake and eat it too. The aforementioned clients who ask for moderate risk/moderate return really want high return managers. To them 2% just doesn’t seem that exciting. We know this because after they choose not to invest with moderate risk/moderate return managers, they return to our complete list of managers, sort by returns and choose the managers with the best short term results. This is not consistent with someone who says they want moderate risk because risk and returns are inversely correlated.

Our diagnosis of this behavior is investors really don’t know how to evaluate risk. It’s not nearly as tangible as returns. One can measure returns by how much her portfolio grows in value. However concepts like volatility (the primary means by which risk is measured) are far less obvious. Clients end up chasing the allure of premium returns, but at a premium risk level, which is higher than they realize or may want if the markets turn south. When viewed in this context, that 50% increase in my retirement savings paired with a lower risk than the market looks pretty attractive.

The challenge for the financial services world is how to best serve our clients when they don’t know what they really want. It sometimes feels like we are trying to get our clients to eat their vegetables when all they want is ice cream. Don’t get me wrong. Ice cream tastes great. It just needs to be balanced out with some healthier choices if we hope to live a reasonable lifetime.

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