Financial Planning & Wealth Management

How to Deal with Risk

How would you feel if your portfolio fell 25%?

 

This is the type of question you get asked when trying to determine your risk tolerance. Would losing 25% of your portfolio be painful? Would you panic and sell out of your portfolio to limit losses? Then you have a low risk tolerance. Would you take it on the chin and even add to your portfolio when it’s down? Then you have a high risk tolerance.

 

This is the traditional way of thinking about risk.

 

I disagree with this traditional way of thinking about risk tolerance and trying to determine a clients risk profile, and consequently, their ‘optimal’ portfolio. I get the implied logic, but this type of profiling seems misleading in the way it makes us think about risk. It makes it worse that these surveys are a regulatory requirement in our industry.

 

I’ll give you two examples illustrating why these surveys are misleading.

 

When we do risk surveys of this type, and we show people 3 portfolios – low risk, medium risk, and high risk – people tend to choose the middle. Great. Now imagine we take the high risk out and we add a lower risk in, so that we still have low low risk, low risk, and medium risk. So, what happens? People will still choose the middle.

 

The second thing is that people don’t take risks with money. At the end of the day, people take risks with their consumption of life. We should actually ask how you would feel if you lost 25% of your stuff. 

 

The reality is that money is a means to an end. For example, I should ask how you would feel if your kids couldn’t go to the school you wanted them to go to. And how would you feel if you had to downgrade your house or move to a less comprehensive medical aid plan. These are the real questions. 

 

And it turns out that there is nothing to connect these two – the risks in life and the risks in money. You ask a person about the risks in their life and the risks in their portfolio and they will give you a very different answer, but these are the same things.

 

So where do financial advisors fit into the discussions on risk?

 

Financial advisors are supposed to be like financial doctors. They are licensed professionals who maintain and build financial health through execution of empirically tested best practices. They should guide you to make the correct decisions, not to a decision that you feel best about.

 

Imagine your financial advisor asked you ‘how do you feel about risk?’ and you said ‘I really hate risk and I don’t sleep well at night’. So, what should they do? Perhaps they should tell you to be poor your whole life? 

 

If I was your doctor and I asked you how you felt about pain and you said ‘Matt, I hate pain’. I’d say ‘you know what, you need this treatment but I am going to give you something for the pain. I will give you full anesthesia, or perhaps I’ll give you painkillers or valium’. 

 

I don’t say I’m not going to give you the appropriate treatment because you don’t like pain. 

 

As a professional, I am going to give you the proper treatment, but I am also going to give you something to deal with the pain. 

 

In the same way, if I was your financial advisor and you came to me and you said you hate risk, I would say ‘don’t look at your portfolio. Take valium, study meditation’.

 

Regardless of how you feel about risk, you need to take the prescribed treatment. 

 

Just because a person feels differently about risk doesn’t mean that they should be condemned to be poor. If somebody is an expert on risk, they should tell you what risk you should be taking regardless of how you feel about it.  

 

The real question we should ask ourselves is what we are trying to achieve in life. Perhaps you say you want to retire on the coast and you want a boat. I would then calculate how much money you need, and your risk will be an output of how you want to live.

 

It’s a strange world where we invest money and say that instead of optimising your future life, we are going to optimise your feelings. 

 

When you think about it, it’s a poor outcome that we got to our current system of risk profiling and determining our ‘optimal’ risk. It makes people think about risk in the wrong way and limits their ability to use the power of the market to achieve what they want in life.

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About

 MattFin is a blog that focuses on wealth management, investments, financial markets and investor psychology. I build financial plans and portfolios for families and individuals

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