Each of us thinks about the risks that we take in our own way. Some people have no difficulty taking risk in their personal lives but are more risk averse in their financial decisions. Others are just the opposite.
We focus our efforts on helping our clients’ better understand the balance between financial risk and their progress toward life goals. We think about financial risks from two perspectives:
- Minimizing threats to financial security by using a prudent amount of insurance to protect against untimely death, disability or long-term care requirements.
- Understanding the amount of investment risk that each client is comfortable taking to achieve a financial goal.
Thinking about risk in both of these ways helps us make recommendations that may increase the likelihood that our clients will achieve their goals.
Insuring against risks is usually clear and less complicated. Defining and responding to investment risks is a different story.
Some clients have sufficient assets and guaranteed income streams (pension, Social Security, property income) to have a nearly bulletproof retirement plan, given their lifestyle preferences. They aren’t reliant on growth of their assets to meet their goals so they choose a conservative investment approach.
Others in the same situation, particularly entrepreneurial folks accustomed to taking risk, prefer to strive for growth beyond their basic income and asset needs. They have a “go for it” mentality to increase their personal wealth.
Then there are folks who have lifestyle ambitions or early retirement visions that aren’t as adequately funded. They may perceive little choice but to have investment returns do the heavy lifting required to meet their outsized goals.
Often, this leads to a misinterpretation of investing vs. speculating. As financial advisors, we think that investing should be done with an expectation of a margin of safety around the expected outcome over a full market cycle. This margin is thin or non-existent if you are speculating.
Speculating may be lucrative. In fact, the greatest fortunes in the world have come from speculating or concentrating investment in a single idea. But speculating comes with potential consequences that can be disastrous, especially if you don’t have a significant time horizon to make up for the setback.
In a rational investment world, you can differentiate between investing and speculating. But clearly, global markets don’t always act rationally and even “good” investments over the past decade have delivered returns that exposed downside risk and appeared more speculative.
As psychologist Paul Slovic is quoted in The Intelligent Investor, Benjamin Graham’s classic book on investing: “risk is brewed from an equal does of two ingredients—probabilities and consequences.” As advisors, it’s important to us to be realistic about our probability of being right and understand how clients could react to the consequences of markets not behaving as expected.
The difficulty in predicting responses to market fluctuation lies in the tough-to-judge emotional responses tied to money. We find that one way to understand the impact of risk and therefore better predict how people will actually respond to market downturns is to measure their loss cushion. How much could they see their assets decline and still be able to support goals, such as a 30-year stream of retirement income, at an acceptable level.
People with relatively little loss cushion need to be far more aware of the risk in their portfolio. This is a fundamental tenant of our financial planning philosophy.
Regardless of our clients’ mentality, it is our role as a Registered Investment Adviser firm, and as Certified Financial Planners, to act as fiduciaries in the clients’ best interest.
As fiduciary advisors, we are careful to manage investments prudently. We ask ourselves:
- Are there unintended risks/consequences in a portfolio—like having too many bonds of one type or too much exposure to any specific country, currency or industry?
- Are our expected returns too low or high?
When evaluating expected returns, we feel it’s important to:
- look beyond long-term averages which create an inaccurate sense of security
- consider fluctuation in historical returns and sequence of those returns, to understand realistic moves from year to year, their depths and their heights
- evaluate attractiveness of investments by fundamental measures, regardless of the present direction of markets
With the answers to those questions, we work to create investment portfolios for our clients that help them manage both their risk levels and return expectations. We focus on:
- Understanding their short- and long-term goals
- Being sensitive to their tolerance for market fluctuation (risk!)
- Knowing the likely holding period of the portfolio
- Working to manage both the expenses and tax implications of the investment portfolio
- Diversifying holdings to mitigate some risk
We understand that from time to time, our assumptions and the probabilities we assign to expected outcomes will be wrong. But as long as we are generally correct in our direction and not precisely wrong with speculation, we will help our clients achieve financial security.
