For most people, it’s difficult to take the emotion out of investing and consider risk on an intellectual level. This is highlighted by the fact that two of the most common mistakes made by investors are selling at the first sign of volatility and having too much cash sitting on the sidelines. The emotional pain associated with the prospect of losing money simply overwhelms the rational side of their brain.
By developing a long-term, goals-based plan, however, advisors can help clients keep risk in perspective. In truth, most investors want the same things, and they’re all pretty simple: to educate their kids, have a relatively comfortable lifestyle and live well in retirement. Advisors should work to help clients focus on these overarching goals, not whether they are content with the level of risk they are taking.
Think about a doctor treating a sick patient. Do they ask them how they feel about taking a particular medication? Almost never. They diagnose the problem, provide a prescription and tell them what they need to do to get better. Advisors need to have the same mindset—it’s not about what clients feel like doing, it’s about what is best for them.
Ultimately, a client’s comfort level with risk is one thing. What they need to do to achieve their goals may be something entirely different, and it’s rare when the two are in alignment. And that’s the essential irony of the risk tolerance questionnaire construct: Even though it was put in place to protect advisors, the reality is that it may increase the likelihood of a client initiating an arbitration hearing or some other legal action when things don’t turn out like they envisioned.
Advisors, though, can position themselves to avoid those potential outcomes by reducing their dependence on poorly worded, off-the-shelf risk tolerance checklists and refocusing that effort on understanding clients’ needs to help them implement goals-based plans.
Greg Luken is founder and CEO of Luken Investment Analytics, a turnkey quantitative research and asset management firm that enables financial advisors to deliver innovative asset allocation strategies to retail investors. He can be reached at [email protected].