The Paradox of Investment Risk

profit-loss-riskMy Comments: First, let’s both understand we are talking about financial risk. Second, financial risk for me is likely to be defined differently from how you define it. Third, there is always an element of uncertainty about any future outcome, whether it’s getting married, having children, accepting a new job, etc. Uncertainty implies a potentially unfavorable outcome for almost anything we do, but to the extent it is “risky” depends on our frame of reference.

For example, walking along the roofline of my house, at age 73, is much riskier for me that it might be for someone age 22, who is a chamption gymnast. Mind you that’s physical risk and not financial risk, but there are parallels when it comes to money.

I’ve just taken a step that caused me to reflect very carefully because it has caused me to trust someone to do something with my money that I personally cannot replicate. For me, I had to come to terms with the “risk” involved because it’s something I can’t do. The person who I’m trusting has done this successfully for the past 35 years. For him, it is considered safe and conservative. Only I don’t “know” that, so there is an element of risk involved.

by: Franklin J. Parker / Tuesday, June 17, 2014

Like most retail financial advisors, I have thought a lot about how to reduce both actual risk and the perception of risk in my client’s portfolios. Since 2008 we have all thought, rethought, written and rewritten about risk.

I focus on financial planning to help clients understand why they are investing. I have had discussions about why portfolio allocation helps to protect clients; I’ve used all the financial metrics and Monte Carlo simulations. But no matter the conversation, it seems that clients see themselves forever in danger of falling off a 1,000-foot cliff — a fall they feel is one small misstep away.

And this, to me, is the real problem with the current wealth management paradigm. We do hours of financial planning work: calculating different saving scenarios, market returns and retirement dates. But when it comes time to actually construct a portfolio, we give the client a risk-tolerance questionnaire that is entirely unrelated to their financial planning needs.

What if a client scores very conservatively on the questionnaire but actually needs a more aggressive portfolio? Or vice versa? To not use the financial planning process to directly inform the investment management process makes no sense to me. Well, actually it does.

Let’s be honest: As an industry, planners continue to use risk-tolerance questionnaires because they are defensible in court. But these do the client a disservice; they let advisors avoid the real conversations our clients need.

We must ask clients which competing risks they are willing to accept: Are you willing to accept the risk of not retiring on time? If not, are you willing to take on more portfolio risk? That is the proper role of a risk-tolerance questionnaire: to inform the conversation about risk, but not to dictate it.

It is an easy thing to calculate the return requirement of a future goal. It seems sensible to assign a portfolio allocation that has the best likelihood of achieving that goal. And, taking this idea a step further, it is not a hard thing to figure out the maximum loss a portfolio can sustain before a plan gets derailed. You can even dust off the old stop-loss tool to help limit the risk of those catastrophic losses.

Using such a process might help give clients context, and a better sense of the risks they are actually willing to take. By assigning a loss threshold coupled with some hedging strategies (even as simple as stop-losses), we can help clients better understand which losses are tolerable and which are not.

This may be the point. As retail advisors, it is our job to keep clients rational and on track. With some safety nets, we may be able to help clients stay rational and not fear that 1,000-foot cliff so viscerally.

Franklin J. Parker is managing director of CH Wealth Management in Dallas.