Bull markets do not die from old age, but they often succumb to events or changed perceptions. Right now, a litany of issues exist that could roil the market’s historic nine-year advance, including China trade tensions, rising interest rates, and charged midterm Congressional elections that could impede President Donald Trump’s pro-growth policies.
Already, some sophisticated investors are hedging their stock portfolios even as economic data and corporate earnings remain robust. This defensive positioning suggests that major investors are starting to worry that corporating earnings, which have grown faster than the economy for the past four decades, may not grow so fast in the near future. To get ahead of whatever may come next, some advisors are starting to discuss with clients something that they have not addressed in years: risk and loss.
Preparing Clients for the Next Big Move
Of all the conversations advisors have with clients, risk and loss are often the most difficult. Many individual investors are scarred from the Global Financial Crisis of 2008. They remember worrying that they would have to delay their retirements, or worse yet never stop working. This creates a tough situation for advisors who have to keep their clients’ temperament in check and their eyes on long-term investment objectives.
Advisors often function as a combination of financial advisors and psychologists. They have to counsel clients against making costly behavioral mistakes, such as panic selling near a market bottom, exuberant buying near a market top, or other ill-timed portfolio changes. A big part of that is ensuring they have properly calibrated their clients’ risk-return profile based on an understanding of their risk tolerance. Any advisors who have not assessed their clients risk tolerance in recent years should consider doing so now.
Advisors Need a Deeper Understanding of Risk Tolerance
According to some studies, after a fairly easy ride over the last nine years, it is unlikely their risk tolerance would have changed much, except for age appropriate adjustments. The studies show that, over time, investors’ risk tolerance rarely changes, even in the face of major market events.That’s because risk tolerance, which reflects our attitude about risk, is a psychological trait, ingrained in us early on. Yet, that thesis does not explain the sudden change in investor behavior during a major market event.
For example, investors with conservative portfolios might suddenly decide to increase their exposure to equities during a raging bull market, or more aggressive investors might decide to unload equities during a steep market decline, even if their portfolios are appropriately aligned with their risk profile. The studies found that, while their risk tolerance may not have changed, their perception of risk probably did. It’s possible for an investor to have a very stable risk tolerance but a very unstable risk perception.
But then, other studies have found that, while risk tolerance does vary over time, it is often influenced by perception of risk.The key point is financial advisors need to look beyond risk tolerance to understand how much risk their clients perceive at any given time to ensure they are providing suitable advice.
What Are Your Clients’ Perceptions of Risk Right Now?
It is the perception of risk – how one views his portfolio or an investment at a particular time in relation to his risk tolerance – that frequently changes. While risk tolerance can be easily assessed, risk perception is more difficult to gauge because it is based on subjective factors, observations and biases that can change over time.
It is also the perception of risk that typically leads to behavioral mistakes. For example, the more aggressive investor, who has a risk tolerance and financial capacity to withstand a 20% market decline may perceive a market decline as being far worse because of on his or her experience in 2008 or even because of comments made by a market pundit over the weekend.
The understanding that clients’ risk perception, which is often the catalyst for bad investment decisions, is typically masked by their more stable risk tolerance is especially important as the stock market dances around record high levels. It’s kind of like the paddling ducks analogy. They may look perfectly calm on top of the water, but below the surface they’re paddling like mad.