The multiple dimensions of risk and tolerance
It’s critical to understand our human strengths and weaknesses to prepare for market change
Quantifying the essential component of risk tolerance for our clients is no simple matter. For years, assessing risk has been more of an overall psychological assessment than anything. The formula, reduced to its basics, was a combination of determining how people remember and react to market fluctuations, an honest accounting of their financial habits and their long-term goals.
Our golden rule is simple: If you can’t acknowledge and handle the realities of markets, then financial planning may become a turn of the roulette wheel with our emotions and our finances spinning around to outcomes sometimes favorable, sometimes not.
There are multiple dimensions to bias and risk. Cognitive biases can distort how we think and react. Recency and confirmation bias can induce comfort thinking, such as “I know what I’m doing because I’ve read the market correctly the past decade.”
In a recent and entertaining New York Times column, Carl Richards combined daredevil skiing, Nobel prize-winner confessions and the human ability to cause avoidable avalanches to present a valuable lesson.
“When we’re betting money on the stock market, it’s important to remind ourselves of something called the self-serving bias, where we take credit when things go well and cast blame elsewhere when they don’t,” Richards wrote. “One of the reasons these biases are so scary is that expertise — the kind professionals are often so certain they have — doesn’t solve the problem. In fact, it might even make it worse.”
Conventional wisdom bias is also tricky. For example, who should be more conservative in their investing goals: a 40-year-old entering the prime of their earning years or a 65-year-old nearing retirement? It would seem on the surface that the older investor might be more conservative, in part because the younger one has time to recover from portfolio downturns.
Not so fast. If the younger, less self-aware investor saves little cash and doesn’t have the emotional tolerance to deal with ups and downs, a conservative approach might be warranted.
Our hypothetical older investor is disciplined in their spending habits, understands their risk tolerances and has a goal to leave a large endowment. This investor can handle riskier options to reach their goal — and they may also have a pension or other guaranteed sources of income. We use many tools at our disposal to help our clients realize and better gauge their capacity for risk.
During the past few years, we have introduced a software questionnaire that helps identify risk tolerances. It has also helped us identity our own risk biases.
If we don’t practice the same “know thyself” approach we preach, we aren’t doing our jobs. That said, these tools are part of a process, not a panacea on their own and never should be.
Wall Street Journal columnist Jason Swieg smartly observed, “On a bland, hypothetical quiz, it’s easy to say you’d buy more stocks if the market fell 10%, 20% or more. In a real market crash, it’s a lot harder to step up and buy when every stock price is turning blood-red, pundits are shrieking about Armageddon and your family is begging you not to throw more money into the flames.”
As we continue on a historically long and unusually rewarding bull market, it’s critical to understand our very human strengths and weaknesses to prepare for change.
A perceptive post a few years ago by Ben Carson on “A Wealth of Common Sense” blog broke down the parameters between so-called “Good Advice” and “Effective Advice.”
In short, good advice is usually obvious (I should eat healthier, I should save more money), while effective advice is next-level (customized plans to eat healthier and save more money). Carson noted among many fine examples that “Good advice is to ignore the noise. Effective advice is to create a comprehensive investment plan which focuses exclusively on those things that are within your control.”
We consider informed planning based on goal-setting, understanding risk tolerances and “knowing thyself” not only effective advice but also the best antidote to chaos, political uncertainty and market fluctuations to come.
Tom Sedoric is partner, executive managing director and wealth manager and D. Casey Snyder is partner, senior vice president and wealth manager at The Sedoric Group of Steward Partners in Portsmouth. They can be reached at thesedoricgroup.com.