But before we can work on how best to endure the ride, we first need to determine whether your client needs to ride the roller coaster at all.
The long-term risk for most clients is inflation. No matter how low inflation may go-the annual rate, presently 2.2%, has averaged about 3.4% over the past 100 years-over time, it has an erosive impact on portfolios. Maintaining an equity position will help mitigate this loss. So we know that most clients need to get on the roller coaster.
But which one? Must it be Australia's Tower of Terror-with its 100 mph top speed-or can it be a milder ride, like Disneyland's Space Mountain?
Nobel Prize winner Daniel Kahneman, in his prospect theory, tells us that individuals feel the pain of losing a dollar twice as intensely as they feel the joy of gaining a dollar. Therefore, investors will seek to avoid loss rather than take on risks to make more profits. We are not risk averse; we are, in fact, loss averse.
This might mean that a less volatile roller coaster might keep your client in the cart and tolerating, if not enjoying, the ride. So if you design a portfolio for less volatility, there is a better chance that your client will stay invested. The downside, however, is that inflation erosion may result in the client's not being able to satisfy his or her goals and objectives. Your job is to help clients balance these conflicting risks.
The way we describe risk tolerance to clients is "that threshold of worry and misery that you can live with, without calling us to say, 'I can't stand it anymore! Sell me out and take me to cash!'" Next we need to help our clients distinguish between risk tolerance and risk capacity, which is the amount of risk your client can sustain financially. Most people can afford to blow a dollar on a lottery ticket, for instance, but few can afford to put $40, $50 or $60 a week for this purpose without sacrificing some other, more beneficial purchase.
Finally, there is risk demand-the risk you need to take to meet your financial objectives. Current and future resources, current economic forecasts and the demand on resources going forward dictate risk demand.
Frequently, your client's risk capacity, tolerance and demand are not in alignment. This is when you can do your best work, setting up what I call a negotiating session. My partner sums it up this way: "Do you want to eat less well or sleep less well?" When you find a balance, you can make a good plan.
Conversations about risk must start the day you meet your client, not when his expectations have not been met and he's feeling buyer's remorse. During volatile markets, my favorite question in our risk coaching dialogue goes like this:
"Please select the statement that reflects your preference:
a. I would rather be out of the stock market when it goes down than in the market when it goes up (i.e., I can't live with the volatility of the stock market).
b. I would rather be in the stock market when it goes down than out of the market when it goes up (i.e., I can live with the stock market volatility in order to earn market returns)."
We explain that we believe, over time, the domestic and world economy will trend up. We also believe that over time stocks will provide greater returns than bonds; however, we also recognize that stock returns will be more volatile.
So, by this framing question we're demonstrating two things. First, we are not market timers and if you are, we may not be the right choice for you. Naturally, everyone would like to be in stocks only when the market is going up. Unfortunately, consistently achieving this goal is less likely than finding the pot of gold at the end of a rainbow.
Second, if you say that you can stay in the market to receive market returns, we will keep reminding you, each and every time you get nervous. We'll even haul out a copy of the questionnaire you signed. We need to know that you will stay on the roller coaster even if you won't be waving your hands in the air.