That means, at least theoretically, there is no best portfolio but rather an infinite number of best portfolios, depending on the risk one is willing to take. We know that everyone would like to have a portfolio with no risk and lots of return. Unfortunately, the real world of potential portfolios lies on or below the efficient frontier. So what does that mean for you?

Well, it means we have to do some planning, and then you’ll have a decision to make. First, as I said starting off, we need to make a best guess about what return your portfolio would need to earn over time to provide you with the money you need to accomplish all of your retirement goals. Then we need to make a best guess about your risk tolerance. If we just focused on your return needs, we might conclude it was possible to achieve your financial goals with a portfolio allocated 90% to stock, but that might not work out so well if we faced a major bear market in a few years. After you saw your nest egg lose 40%, you’d call us and say, “Harold, we can’t stand it. Please sell our stock and put our money in cash!”

That’s why we define risk tolerance as the point of pain and misery you can survive—with us holding onto your belt and suspenders—just before you make that call to tell us to sell out.


With those two anchors, we can now revisit our graph. We have two portfolios for you. Portfolio A is one that provides you the return you need to achieve your goals, and B is one in keeping with your risk tolerance, which is higher than what we used for Portfolio A. Which one is right? In fact, both are, but our recommendation is to plan on Portfolio A. Why? Even though we believe you can live with more risk and would end up with more money, determining risk tolerance well in advance of a terrible market is more art than science and the consequence if we’re wrong and you bail out of the market would be catastrophic. So why take that extra risk if you don’t need it to achieve your goals?

How about if we found a different outcome? Suppose we concluded that you needed Portfolio A to provide your needed return but had less of a risk tolerance that would allow for those returns?

That’s not so good, because now you have to decide between eating less well or sleeping less well. In this case, our recommendation would be to readjust your goals to meet the return expectations of Portfolio B. Why? Again, when markets seem OK, it’s all too easy to say, “I’ll take a bit more risk.” But later, when it seems the world is coming to an end, you’re not likely to remember your willingness to hang in there.”

Illustrative tools can make your conversations with clients so much more interesting and effective. You might think about various concepts that you have had difficulty conveying to clients in the past and draw or graph these in simpler terms. Then try them out on an older, non-professional relative. 

Deena Katz is an associate professor in the personal financial planning department at Texas Tech University, a partner in Evensky & Katz in Coral Gables, Fla., and the author of several books on planning and practice management.
 

First « 1 2 3 » Next