For many investors, the beginning of the year is a time for them to review their investing strategies and reassess their risk tolerance. Though the U.S. stock markets have been on an incredible run last year, recent polls of economists and American voters indicate great concern about a looming recession.
This means that advisors need to be in tune with the changing needs of investors and actively assess the risk that they are willing to take in a potential bear market. Inaccurate, confusing or outdated investment risk assessments could result in investors with unrealistic expectations and pose a major risk for financial advisors.
Risk Perception
Risk tolerance, which is an investor’s willingness to withstand variable investment returns, is only a small component of managing risk for clients. Investors may believe that they have a high risk tolerance and are able to handle downturns in the market, but they may not actually understand how to be prepared in a bear market. This is why advisors need to consider a holistic view of a client’s perception of risk. Goals should be evaluated frequently to ensure that investments match time horizons. Advisors should also assess the investors’ understanding of risk. Do they know what percentage of their investments are stable, and which may be lost in a market downturn? Although they may feel prepared to take risks while the markets are looking up, that perspective can quickly change when the market takes a dive.
Other risk determinants that should be considered by an investor are risk capacity and risk perception. Risk capacity relates to the amount of risk that the client can actually afford to take or needs to take to reach certain financial goals, regardless of their perception of risk. This capacity can change based on age or lifestyle factors, and it needs to align with an investor’s time horizons and goals. Risk perception is psychological, and refers to how an individual will actually process financial losses. Although investors may feel like they can and want to take risks, recessions create a very different risk assessment, as investors will see what these risks look like in actuality. Poor investment advice in a market downturn can result in legal liabilities for advisors and could turn investors away from the market completely.
Aligning Investor’s Risk Tolerance
Advisors need to be aware of a number of factors in order to set investors up for success. Alignment on the goals of the investment funds, including the time horizon, will be especially important when deciding the mix between equities and fixed income investments. Typically, younger investors have longer time horizons for their investments, as retirement can be close to 50 years away. This allows them to take more risk and invest a higher percentage in equities. In a potentially unstable market, though, it is still important to ensure that their investments are not completely lost. Traditionally, a balanced portfolio of equities and fixed income, with a diversified portfolio, will ensure that investors reap the benefits of the bull market, but are prepared for a downturn. Consider other large purchases that the investor may want to use the fund for, such as a child’s education. These may have shorter time horizons and the investments will need to be adjusted accordingly.
Older investors may be more hesitant to take large risks with their money. With the 2008 recession still on their minds and their retirement age approaching, older investors tend to be more conservative with their money. Although this was commonly the best approach, as life expectancies increase, this strategy is changing. In order to reach certain financial goals or maintain certain lifestyle expectations, older investors may want to consider a riskier approach to investing. Advisors need to understand an individual's expectations with their money first, before explaining the factors behind risk and reward.
Improving Risk Assessments
Strategies and technologies are evolving to better assess how risk is viewed by investors. Risk questionnaires are becoming more robust, yet less complex, to ensure that investors understand what is being asked of them. They also are being developed to distinguish between the attitude towards risk and the investor’s ability to actually take on risk. This relies on psychometrics, which is the science of measuring mental capacities and processes. Instead of defining comfort level rigidly as conservative, moderate or aggressive, advisors are also starting to rely on risk numbers to form a more complete picture of their clients’ abilities to take risk, their comfort with risk and the amount of risk that they will need to take to reach their goals. These risk number profiles assign investors a number on a scale ranging from zero to 100.
Risk assessments also need to change based on technologies and how investors are accessing these questionnaires. Software programs are emerging that have the capabilities to delve deeper into comfort levels, resulting in a clearer risk assessment. They are also becoming more user friendly and accessible, allowing the average investor to complete their portion of an assessment on mobile devices.
Although questionnaires and advising software are evolving to improve the client experience, advisors also need to evolve to meet the needs of investors. Banks are increasingly offering robo investing, where clients receive minimal personal connection when making their investment decisions. This means that, in order to maintain client connections, an advisor’s personal approach needs to add value for the client. Communication and understanding can go a long way in ensuring that an investor is happy. This, in tandem with scientifically crafted questionnaires, can help advisors better assess a client’s true risk profile and potentially deliver better outcomes.
Preparing For What’s Ahead
No matter the market outlook, advisors and investors need to be prepared for downturns. To maintain their clients’ trust, advisors need to prepare them financially and mentally for any market upsets that may take a toll on their investments, and by extension, their ability to achieve their financial goals. By considering the factors behind an individual’s risk tolerance and approaching risk assessment in a more personalized way, advisors can be more successful in providing a portfolio mix that specifically suits each client’s needs and expectations.
Christopher Crawford is the Director of Advisor Relationships at Buffalo Funds. With over 10 years of experience working with financial advisors supporting their business development efforts, Christopher notes that success for advisors begins with being a good communicator and a better listener.
Buffalo Funds is an asset manager with 10 actively-managed, no-load mutual funds, Mission, Kansas.
© Buffalo Funds
Read more commentaries by Buffalo Funds
