Many firms use “risk tolerance” questionnaires to determine this for their clients, but a client’s risk tolerance isn’t a static measurement like their height; it varies over time.
“Risk tolerance” is a terrible term because it encompasses three different factors:
- Risk capacity – how much risk the client can afford to take.
- Risk propensity – how much risk the client is comfortable taking.
- Risk recognition – how much risk the client thinks there is.
Frequently all three are muddled together, but even at best the last two are usually combined.
As mentioned above, one of the long-standing issues with risk tolerance (with that muddled definition) is that it isn’t stable, and it appears to be the third item, the recognition, that is the issue. During bull markets people don’t have higher risk propensity, they just think there isn’t any risk! During bear markets, they think there is lots of risk and act like their risk tolerance has declined. It hasn’t – they just feel like there’s more risk present.
Questionnaires won’t get you anywhere on that.
Instead, we have a conversation with clients using some market history (from Ruminations on Investment Philosophy):
From peak to trough, U.S. stocks declined in nominal dollars by 45 and 55 percent in 1973-1974, 2000-2002, and 2007-2008. Therefore, during poor markets, investors should expect the risky portion of their portfolios to decline by approximately half. The “risky portion” is everything that is not investment grade bonds or cash. This is the necessary pain to achieve the higher returns that are expected from risky assets. This is not a “worst-case” scenario, it is the periodic expected case. If stocks did not occasionally experience losses, they would cease to be priced attractively enough to earn superior returns. It is our job to make sure client portfolios are positioned at an appropriate level of risk and that our clients do not increase their risk-taking when things look rosy (e.g. 2006) and do not decrease their risk exposure when the outlook is frightening (e.g. 2008). [Emphasis in the original]
As part of the conversation, we tie the information to their specific situation: “You have a $5,000,000 portfolio which we have recommended be invested 60/40. That means you could wake up in a year and it would be worth $3,500,000. Imagine that has happened and the media is screaming that the wheels are coming off of capitalism/civilization, and we are going into another great depression. How would you feel?”
Then, we let them talk. They still won’t be able to accurately judge how they would really feel in that situation, but we can get a sense of where they are. It helps if they are older and have been through bad markets with significant funds. Having gone through the GFC with a $200,000 portfolio, while still working, and not panicking is not the same as going through something similar now, retired, with a $4mm portfolio.
Advisors should almost always think in percentages, but often clients react to dollars.