DENVER -- Financial advisors often get clients' risk tolerance level wrong, and yet getting this right is the key to building durable portfolios.

So said David Lafferty, chief market strategist at Natixis Global Asset Management, who spoke Thursday at a session titled "Thinking Differently About Risk: Debunking Common Myths" at the Schwab Impact conference here.

Long-term investing is great in theory but dicey in practice, he said.

Lafferty said that he believes in mean-variance optimization according to the risk tolerance of the client, but questionnaires fail in mathematically determining the portfolio allocation on the efficient frontier.

Another method of developing goals and objectives and designing the portfolio allocation to maximize the probability of success completely ignores the level of risk, and the client won't stick to it, he said.

The client's asset allocation should be set at the maximum level of risk that he or she can stand in order to maximize the return, Lafferty said.

That maximum level is at the point where the client won't call the advisor in a panic after a market decline.

There is biology behind risk and fear, Lafferty noted.

The brain's thalamus alerts the amygdala, which alerts the hypothalamus, causing us to take action. When the client's statement shows a 15% loss, memories are triggered, and the action is taken with the intent to avoid that prior painful memory.

The client will insist on selling low, and Lafferty showed fund flow data to support this irrational behavior.

Three Myths

In addition, he said that there are three myths related to risk.

The first myth is that advisors confuse what should be and what is. They think they know what the client's risk should be and that they can set the level of client risk.

For example, Lafferty said, a young client with many years before retirement should take a lot of risk, but the reality may be that the client won't accept it or stay the course after a market decline.

Advisors make assumptions about clients' risk tolerance, which is a value judgment, and clients will usually feel better about risk if they think that they were part of the process of setting the risk, Lafferty said.

The second myth is that clients are long-term investors, but clients can't help but look at their statements and have fear and greed take over, he said.

Time diversifies portfolio returns as measured in percentages but only if the client stays the course.

But Lafferty pointed out that in total dollars, it is actually the "fallacy of time diversification" as variances actually increase.

Even so, he said that advisors want clients to be long-term investors but that isn’t the reality.

The third myth is that advisors can feel their clients' pain.

But the reality is that advisors can't because they are professionals who understand markets better than clients, and while advisors may look at standard deviations, clients just look at losses, Lafferty said.

Translating these three myths into portfolio construction involves looking at the potential downsides. Two standard deviations (95% confidence) is one way.

Advisors may want to use three or four standard deviations to show the potential loss in percent to use the "scare factor," which is better than any theory, Lafferty said.

So the capital asset pricing model is alive and well, as advisors must first start with risk, a necessary evil to get returns, he said.

Lafferty advised educating clients and planning ahead for bear markets so clients will feel more in control.

Advisors can encourage long-term investing but shouldn't expect it, he said.

Err on the side of caution to avoid reducing risk after losses, Lafferty said.

Always talk about the portfolio rather than any individual holding, and go beyond the risk questionnaires as the way clients feel abut risk isn't stable, he said.

So how much risk should a client take? History, experience, style, personality, age, current wealth and time horizon all come into play.

The key to building a durable portfolio is getting the risk tolerance right, Lafferty said.

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