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5 Secrets Your Financial Advisor Doesn’t Want You to Know about Risk Tolerance

What Your Wealth Manager Should Be Asking About Instead

 

One of the first things most financial advisors and wealth managers ask potential clients is, “What is your risk tolerance?”

This is a loaded question. Behind it lies a whole host of assumptions, guesses, feelings, and implications – few of which are typically discussed before or even after you are asked about how much risk you can tolerate in your high net worth investment plan.

In this article, we’re going to blow the lid off the risk tolerance black box so you can more properly understand how this term applies to ultra-high net worth investors like you. Then, we’ll look at how it should be used to help create the investment plan that will deliver the performance and financial security you seek.

Here are five secrets about risk tolerance your financial advisor doesn’t want you to know about (or, if they are out of their league and don’t know their stuff, they may not even know these secrets themselves).

 

Secret 1: Risk Tolerance Is Not a Feeling

Most of our high net worth friends and pretty much anyone else who has sat with a financial advisor and heard their pitch gets asked about risk tolerance, and it usually gets presented as if it’s a feeling.

 

“How would you feel if the market crashed and you lost 25% of your portfolio?” Here’s a questionnaire that uses a question very similar to this. They then use a point value system to “determine” your risk tolerance as if it is a fixed quantity.

“What is your investment attitude?”

This would be followed by choices like conservative, aggressive, moderately aggressive, and so on.

Here are two questions developed by researchers as part of a 20-question risk tolerance analysis:

In addition to whatever you own, you have been given $2,000,000. You are now asked to choose between:
a. A sure loss of $500,000
b. A 50 percent chance to lose $1,000,000 and a 50 percent chance to lose nothing

Here’s another common one:

Which of the following statements best describes your investment philosophy?

– I feel comfortable with stable investments

– I am willing to withstand some fluctuations in my investment

– I am seeking substantial investment returns

– I am seeking potentially high investment returns

We could list many more.

The greatest flaw behind all these questions is that none of them relate to your actual life situation. They are without context.

 

Do I want a sure gain of $500,000, or a chance at $1,000,000 with a risk of $0? It depends. What is the rest of my portfolio doing? How far along am I toward achieving my short-term and long-term goals? What is happening in the world right now? In my family?In my career and business?

 

Am I comfortable with some fluctuations in my investments? It depends on many of the same issues.

 

How would I feel if the market and my portfolio lost 25%? It depends.

 

None of these questions have any solid foundation underneath them. They are all just feelings, given in the moment in an attempt to get through the financial advisor’s consultation process.

 

Risk tolerance is not a feeling. It’s a computation, calculated based on the short and long-term financial and lifestyle desires and dreams you are trying to achieve.

 

Learn How to Balance Risk with Performance without Sacrificing Financial Security

Schedule a Free Chat with CEO and Co-Founder Hutch Ashoo

 

Secret #2: Risk Tolerance Is Meaningless without Context

 

Following after the first secret, you cannot talk about risk tolerance without talking about the goals and lifestyle dreams of the investor. These are inseparable.

For instance, we once performed planning for a family who believed they needed $34,000 per month to sustain their lifestyle throughout their retirement. They had $5.8 million in liquid assets at the time, as well as some income-generating real estate. They loved to golf and scuba dive.

 

Their main question to us was:

 

“Can we have $34,000 per month without taking on too much risk?”

 

Everyone is asking this question. The only thing that changes is the numbers. When investors say they want performance, what they really want is financial security and their desired lifestyle without too much risk.

 

To answer a question like this, we can analyze how the investor’s portfolio is projected to perform under various scenarios. By adjusting for risk tolerance, we can then develop a plan that achieves the goals of the investor. But do you see how you must begin with the context? Their goal was $34,000 per month without sacrificing retirement security.

 

With that goal in mind, we then incorporate a risk tolerance that will help achieve that plan. As it turned out in this case, they were actually able to spend an additional $40k per year without sacrificingfinancial security. Weren’t they happy they didn’t begin the process with risk tolerance!

 

Secret #3: There Is More than One Kind of Risk

Most people – and most advisors who ask about risk tolerance – only think about one type of risk: Market risk.

 

What is market risk?

 

Market risk refers to how likely an investor’s portfolio is to gain or lose money based on the performance of the market. So when COVID-19 crashed the markets by over 30% in less than a month, portfolios with high market risk lost a lot of money. And this happened to a lot of high net worth investors, because many of them are exposed to too much market risk.

But market risk is just one of at least six types of risk. Here are five other types of risk:

 

Political Risk

That’s when your investments or businesses are at risk of being greatly affected by political events, or decisions made by political leaders. If state or federal government changes a tax policy, for example, that can greatly affect your investment performance.

 

Currency Risk

This is when your assets are vulnerable to losing value if they are heavily tied to a particular currency. If you have substantial foreign investments, you probably have some currency risk.

 

Business Risk

Anything that threatens the profits or financial goals of a business is business risk. For an obvious example, when WeWork failed to achieve its IPO[link to blog 46], this negatively affected their profit projections. For anyone who had invested money in WeWork before this point, perhaps through venture capital or private equity, the company’s failure to land an IPO was a bad day.

 

If you are heavily involved in venture capital and angel investing opportunities, you very likely are exposed to substantially increased business risk. In the same way, if you invest in particular company stocks, your success is more dependent on the success of those companies. You are exposed to business risk through them.

 

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Liquidity Risk

When short term financial requirements overwhelm a company and they have trouble coming up with the cash to pay them, this is liquidity risk. Sometimes, the company may have to sell some assets or find another way to generate the cash. When they do this, it can lead to financial losses, hurting their stock price, among other things.

 

If you are invested in companies with high debt, for example, and something like COVID-19 comes along and their income shrinks but their financial obligations don’t, the company can go under. J. Crew is one recent example of a company felled by liquidity risk.

 

Concentration Risk

Lastly, many investors have too much of their portfolios wrapped around a small number of companies, sometimes just one. The most common scenario for concentration risk is owning stock options in your own company.

 

When AOL/Time Warner lost $100 billion in a single year (still the record) back in 2002, Ted Turner lost 80% of his wealth. He was overly concentrated in a single company – his own.

 

But many other high net worth investors make the same mistake all the time. They are paid in company stock options, and they hold on to them, sometimes for decades. All it takes is for your company to suffer a major setback, or get passed up by an upstart competitor, or become obsolete because of technology, and you can lose stock value that will never return.

 

Concentration risk is one of the most common risks we see in the portfolios of our ultra-high net worth friends and clients.

 

How do all these types of risk factor into risk tolerance?

Because the danger of risk extends far beyond market risk. When you are asked about your risk tolerance, do you consider the other five types too? Does your advisor?

 

Does your financial advisor have a plan that hedges against political risk, for example? They sure better, because we have elections every four years.

 

Secret #4: Some Risks Are More Controllable than Others

Given the types of risk just listed, you can quickly realize that some of these are within your control to much greater degrees than others.

 

Concentration risk is probably the easiest one to control, which is why it’s even more distressing that it remains so common. Just don’t do it. Diversify. Develop a more secure asset allocation.

 

6 Keys to Determining your Best Asset Allocation [link to blog 84]

 

Yet, this can also be easier said than done. Unwinding highly concentrated stock options isn’t always as simple as just selling them all, because this can incur a large tax bill. How you achieve this can be complicated, and this is one of the primary benefits of working with an experienced wealth manager who works exclusively with high net worth and ultra-high net worth investors.

 

Learn How to Balance Risk with Performance without Sacrificing Financial Security

Schedule a Free Chat with CEO and Co-Founder Hutch Ashoo

 

Market risk is more outside your control, but you can reduce it by wide margins with an optimized investment plan and a smart asset allocation.

 

Political risk is almost completely outside your control. The other risks often depend on specific companies or industries, but sometimes those risks are linked to some of the others. In other words, there are many ways for a company to fail and for your investment in it to take a hit.

 

Secret #5: Risk Alone Does Not Equate with Security or Performance

Higher risk often means less financial security, and it doesn’t usually translate to higher performance. However, the opposite is not true either. Low risk can also mean less financial security, and it doesn’t usually result in higher performance either.

Risk tolerance doesn’t equate with financial security until you develop a plan that forces it to.

Taking a higher risk with your investments carries with it the potential for a greater reward, but also a greater loss. Therefore, true security doesn’t come from pursuing the highest performance, because you can’t earn the highest performance without also carrying the highest risk.

 

True security comes from maximized optimum performance.

At some point, a focus on pure performance – and the greater risk that must accompany it – erodes your security more than strengthens it.

Pillar Wealth Management pursues optimum performance for all our clients. We develop customized investment plans that begin with your goals and lifestyle context – what you want. We start there, and we build a plan that assures you of achieving it to the greatest extent possible. That plan incorporates a risk tolerance that is commensurate with whatever you are trying to achieve.

You don’t begin with risk tolerance. You begin with outcomes, goals, and lifestyle desires.

If you want to see how we would do that with your portfolio, and how we will place you firmly in what we call the Comfort Zone – the place of optimized performance and blissful financial serenity – then click the link below and schedule a quick call.

Learn How to Balance Risk with Performance without Sacrificing Financial Security

Schedule a Free Chat with CEO and Co-Founder Hutch Ashoo