Confucius wrote, "For one word a man is often deemed to be wise, and for one word is often deemed to be foolish. We should indeed be careful what we say." When we ask our clients how much "risk" they are comfortable taking when investing their money, is that what we really mean?
Think of what the average person visualizes when he or she thinks about risk. Webster defines risk as "the chance of injury, damage or loss."  No wonder so many of our clients are "risk averse." Who wants to expose their money to such catastrophes? Aren't we really asking how much fluctuation they are willing to endure in order to reach their goals? We have been using the word "volatility," but I actually believe that that is also too strong a word for what we are trying to convey to our clients.

Fluctuation, however, is exactly what we really mean when we talk about investment risk. And our clients experience fluctuation every day. The weather fluctuates, prices fluctuate, performance of their favorite athletic teams fluctuates. They don't think of fluctuation as being risk. It is simply the way of the world. Would any of them consider shopping to be risky because prices change from time to time? Most would not. It seems to me that only the most adventurous among us really want to take on risk, so why do we use such a highly charged word when we, in fact, mean something entirely different?

We have discovered that defining risk for what it really is results in our clients making sound investment decisions that significantly improve their chances of reaching their goals. They need to be told that the greatest risk they face is running out of money while they are still alive. Or, not reaching the goals that are very important to them, such as educating their children, traveling, purchasing a vacation home, donating to their favorite charities, etc. Fluctuation may be what they encounter along the way, but the real risk is not earning a large enough return to do things they want in life. I certainly know that "risk" is the commonly accepted word for describing what we really mean as fluctuation or volatility. But that doesn't mean that we must continue to use that label. If there is a better word to describe what we mean, why not make use of it? The technicians define a "risk-free investment" as T-bills. The "reward" we get for investing in a more volatile investment, such as common stock, is defined as the risk premium.
While that may be okay for the academics, it will mean little to our clients who don't reach their goals because they were risk-averse. What if our client tells us that she wants to take no risk in her portfolio? Therefore, she tells you that T-bills, short-term high-quality bonds and CDs are the only investments that she would accept. Perhaps she would accept some "risky" investments, such as a stock mutual fund, but "no more than 10%." She couldn't afford to lose more than that. Of course, she is defining risk as "losing all of my money."  

We know better, and most of us would attempt to educate her. However, as long as we are using the same terminology as she is, we may not be very successful. Some words are more highly charged that others, and "risk" is certainly one of those words. Regardless of how well we think we are at communicating, if we tell her that she needs to accept more risk to reach her goals, we are not likely to be successful in changing her behavior.  She already told you that she wants to avoid risk, and even if you are successful in the short run, she is likely to "bail out" at the first sign of market volatility. She may even remind you that she was unwilling to accept any risk.

As Joseph Conrad wrote, "He who wants to persuade should put his trust, not in the right argument, but in the right word." So let's define risk for our clients for what it really is-the possibility of not reaching goals. And let's define the ups and downs of the market for what they really are-the fluctuations one will probably encounter while on the road to reaching goals. What if our "risk-averse" investor needed a return of 3% over inflation in order to reach her goals? And assuming a 30-year time horizon, we discover that T-bills never returned 3% over inflation over any 30-year period.
What if our research also tells us that a well-diversified equity portfolio (consisting of large stocks, small stocks, value, growth, international, real estate, etc.) returned at least 3% over inflation in 95% of all 30- year periods studied? So now we ask our client what would be a riskier investment strategy: a portfolio that had zero probability of her reaching her goals, or one with a 95% probability. Once we have defined risk as the inability to reach one's goals, the answer becomes obvious. Fluctuation, however, is what our client will experience in this portfolio that is actually less risky than the one she would have had us construct for her.

Recently, a new client who was retired told us that he wanted no risk in his portfolio. His investments were with a major brokerage firm and his broker had followed his client's instructions and constructed a portfolio of high quality bonds of various maturities and no equities. His broker had taken the easy way out and, in spite of the fact that he was withdrawing an unsustainable amount from a portfolio invested 100% in bonds, never bothered to tell the client. We did. I'm sure the broker had his client complete a risk tolerance questionnaire and made investment recommendations based on it, but that was not serving our client well.  

The client told us, as he did his broker, that he did not want any of his money invested in stocks because he could not handle the "risk" (of course, he meant fluctuation). Our long-term projections demonstrated that he was on target to run out of money in 12 years. We asked him if this was a risk he was willing to take, or would he be willing to accept some fluctuations and years when the portfolio had negative returns in order to significantly increase his chances for success. We framed the bond portfolio as the risky strategy, which it was. We didn't ask him to accept more risk to achieve his goals. He probably would have balked at that. We asked him to accept more fluctuation and less risk. The result was a balanced portfolio of 50% equities and 50% fixed income. Will he fret over fluctuations? Perhaps he will in the short run. But if he calls, we will remind him that fluctuation is the price he is paying to avoid the sure risk that he will run out of money in his lifetime.

As financial life planners it is our duty to help our clients achieve their goals. Constructing portfolios based solely on the academic concept of "risk tolerance" may be abdicating our primary responsibility, if that investment strategy has a high probability of failure. When faced with the prospect of either accepting more fluctuation or changing their goals, my experience is that clients almost always choose to accept portfolio fluctuation as a price they need to pay for getting what they want out of life.  In my opinion, financial advisors place too much emphasis on "risk tolerance" when portfolios are being designed for clients, and in many cases sacrifice the long-term financial welfare of their clients.

Mark Twain wrote, "The difference between the right word and the almost right word is like the difference between lightning and the lightning bug."  Risk may be the "almost right word," but fluctuation is the right one.

Roy Diliberto is chairman and founder of RTD Financial Advisors Inc. in Philadelphia.