Many inexperienced investors are terrified of risk, especially during market dips and after the recession that so publicly devastated the economy in 2008-2009. Clients may need some assistance to rip off the Band-Aid and develop a strategy maximize gains with an adequate risk-tolerance.
Educate Clients on Types of Investment Risk
Clients must be aware that there is no way to avoid completely risk while participating in the investment markets, but prudent financial planning professionals should be able to help educate clients and help them become comfortable within the investment markets. That means helping them minimize risk and maximize returns. The first step on this path is to break down the three major types of investment risk:
1) Loss of Principal
Loss of principal is when the investor loses a significant portion of, or even all of, their initial investment. For example, an investor purchases ten shares at $100 per share for a total initial cost of $1000. If the market dips soon after, and the value of their shares is now $90 per share, their total investment value would be $900. At this point, this is only a “paper loss,” a loss that is not yet realized. However, if the investor panics and decides to sell their shares at that point, the loss is realized and they have lost $100 of their principal, along with any fees and commissions that might increase their losses. Knowing the difference between a paper loss and a realized loss is one of the primary steps in understanding investment risk
2) Loss of Purchasing Power
In many cases, clients don’t understand the true definition of purchasing power. Purchasing power is the real world value of money, i.e. purchasing products or services. The loss of purchasing power indicates that the same sum of money no longer has as much value to make these purchases that it previously held.
An easy way to explain this concept to a client is with an illiquid asset like a Certificate of Deposit, a CD. Let’s say a client invests $500 into a 60 month CD with 2% APY that is compounded monthly. In five years, when the CD matures and can be redeemed, that initial investment has a total value of $600, a positive return of $100. However, when purchasing power of the realized gains are taken into account, the true return might be different.
Assume that inflation is at 3% per year, just above its historical average. This means that the $600, five years later, has less purchasing power than the initial investment of $500, because the 2% APY was not able to keep up with the annual inflation rate.
3) Outliving Assets
If clients never develop any internal risk-tolerance and remain on the path to only investing in low-return investments that they consider “safe,” things like CDs and government issued bonds, they run the risk of outliving their assets. It’s important to lower the bar a client’s risk-aversion to help keep them from only putting money towards low-return investments. This will ensure that their investments will grow quickly enough to keep up with inflation and later needs.
What is Their Risk Tolerance?
This isn’t exactly an easy concept to illustrate. Some clients may believe that they can weather the storm if their retirement accounts drop 20% due to market climates. However, when faced with an extreme market dip or crash, emotion might take over and they might panic and sell, locking in their paper losses during the volatility.
Oftentimes, risk-tolerance questionnaires given by investment management professionals are imprecise and do not take into account behavior during an actual crisis. At this time, though, these are the best tools available. In many cases, it becomes the duty of a prudent financial advisor to weather the storm and keep clients from panic-selling during a crisis, if the advisor believes that the assets will sufficiently recover when the markets rebound.
One way to help clients prepare for an eventual market calamity, it is important that they understand their risk-tolerance preferences first. This allows them to be better equipped to participate in designing the right investment mix for their retirement planning or other long term goals with their financial planner. Plans designed to withstand rough seas while the winds are still calm will have a better chance of surviving the eventual storms of market crises.
Helping the Risk-Averse Client Invest
Once in a while, you’ll run into a client who is unable to let down their guard regarding risk. Their fear of loss prevents them from looking at investments with higher returns. Here are a few tips for ushering them towards a successful portfolio with limited risk and maximized gains:
It’s crucial for extremely risk-averse clients to maintain an asset allocation that gives them room for diversification. For long-term investors, the recommended standard is that 60% of their portfolio be invested in stock index funds while 40% is held in bond index funds, often referred to as a “60/40 portfolio.”
True diversification also means that it’s also important to encourage clients to avoid “timing the market” by cashing in and selling out of investments hoping to increase returns and minimize losses, before rebuying an asset. Explaining the difference between the tax rates for long-term and short-term capital gains, along with the “wash rule,” can help eliminate this practice. No one wants to pay high taxes multiple times for the same appreciating asset.
2) Selection of Bonds and Bond Funds
For investment management clients who are extremely risk-averse, bonds are commonly considered as a safe investment. Bonds, on average, are historically much more stable and less volatile than the average stock investment. The decade leading up to 2015 saw the ten year Treasury bond (the benchmark for bond returns) give investors a 4.71% average rate of return. This includes a small profit over the average historical inflation rate.
With interest rates expected to rise in 2016 and the next few years, short and medium-term bond funds might be a sensible investment. For high net worth investment management clients, it could be advantageous to purchase individual corporate or municipal bond products instead of a bond fund. Individual bonds can be very favorable in the right conditions because of the additional income stream, along with the principal value of the bond as it reaches maturation.
Risk-tolerance is among the foundational aspects of prudent financial management. Understanding client risk profiles, along with educating clients about risk tolerance so they can best determine their risk tolerance, will assist prudent financial advisors in developing well-diversified, balanced portfolios for their clients. These balanced portfolios will hopefully subdue client panics when the market becomes stormy, allowing the portfolio to rebound when conditions improve, while also allowing for maximum returns when the winds are blowing in their favor.