Using Risk to Make Better Investing Decisions

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Using Risk to make Better Investment Decisions

When most people hear the word “risk,” they instinctively recoil. Research tells us that just seeing that word on your computer screen caused an imperceptible rise in your pulse and in the speed of your breathing. In fact, a few years back, when I announced I was founding a company called “Riskalyze,” I had more than a few people ask if we really wanted to associate ourselves with such a negative word!

Conventional thinking would say that it’s an adviser’s job to try to minimize a client’s worries about risk. Such thinking would argue that if clients are considering their risks, they’ll invest with a short-term outlook or try to time the markets based on their feelings. Such advisers just focus their conversations on the long term and speak as little about risk as possible.

I have a very contrarian view on such thinking. The very best advisers are embracing the opposite approach: They’re using risk to make better investing decisions in the first place, and they’re ensuring that their clients are invested within the bounds of their risk tolerance. I call it being a “risk-aware adviser.”

Let’s be clear on what the data show: People who are invested outside of the bounds of their risk tolerance are the ones who freak out when the market pulls back, and they demand that their adviser sell at the low. Then they wait until it “feels safe again” and jump back into the markets at the high.

Rinse and repeat until the money is gone.

Imagine if, instead of sweeping risk under the rug, we embraced it to make better investing decisions in the first place.

Imagine if we quantified a client’s risk tolerance and a comfort zone for the portfolio over a relatable period of time (I’ve found six months to be the best). We could then build a portfolio with a high mathematical probability of staying within that comfort zone.

Is this stacking the deck? Absolutely. And that’s exactly what clients are paying their advisers to do: help them grow their assets when the markets are up while protecting their downside risk when the markets drop.

Of course, this approach won’t stop the effects of a black swan event. Those kinds of risks are inherent in the markets, and even risk-aware advisers and investors can’t eliminate another 2008 crisis from happening. But our focus is on handling the other 95% of the mathematical probability that we can control.

Let’s map this back to how a typical adviser thinks about clients right now. A typical growth and income client might be comfortable with their portfolio ending up between–7% to 11% over the next six months. A portfolio to fit that comfort zone probably has an average annualized return of 4% over the course of 20–30 years.

Now, do we talk about that long-term average annualized return with the client? Well, during those 30 years, it’s pretty unlikely you’ll ever hit exactly 4% in a given year. And that’s also true if you look at the broader market: The average annualized return is a nice number, but you get there with a bunch of steep gains and steep losses.

So instead, we’re going to focus on the client’s comfort zone with risk. This changes the dynamics considerably. Instead of a client wondering why the portfolio’s return fell short of 4% or why it didn’t exceed the market last year, the focus shifts to, did we stay within range?

Instead of a client watching his portfolio take an “uncontrolled” dive and frantically calling to order you to sell everything, the inevitable market pullbacks are much likelier to keep the client within the bounds of his risk tolerance, so he’s able to sit back and know that the long-term dynamics of the market will help him achieve his plan.

Typically, the greatest fear that advisers have with this approach is: What happens if my client’s risk tolerance isn’t aligned with his plan? What if he isn’t willing to take the risk he needs to take in order to achieve his plan?

Well, here’s the simple answer: Would you like to know that now, or would you like to find that out when the client’s portfolio drops 10% and he is demanding that you sell everything immediately?

Risk-aware advisers don’t try to fight the mathematical data of risk tolerance. They know that in the face of a market pullback, trying to swim against a raging current of raw emotional fear is a battle they simply can’t win.

It is better to have that conversation with your clients up front; drill deep into their feelings about risk tolerance, and either shrink the goals in the plan or watch the shrunken plan expand your clients’ risk tolerance.

Risk-aware advisers are also bringing this conversation to the very first interaction they have with clients ― winning their business. Nothing brings new prospects aboard faster than showing them how far outside of their comfort zone their current portfolios are.

I’m convinced more than ever that the contrarian view is right: Risk can indeed be an adviser’s best friend. Risk-aware advisers are changing the game to their benefit and using risk to help their clients make better investing decisions. That’s innovation at its best.

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9 comments on “Using Risk to Make Better Investing Decisions

  1. Steve Ricketts said:

    My hat is off to Aaron Klein and his Riskalyze Team. Their risk technology is what the industry has needed and was lacking. I wouldn’t want to deal with an advisor who was not up-to-date with this approach and knowledge.

  2. James R said:

    Riskalyze is the real deal in risk questionnaires and portfolio design/management. Mom and Pop need to know how much risk their portfolios have and advisors need an unemotional tool.

  3. Advisers need to start embracing risk-awareness. Honestly, there isn’t any excuse for not understanding it or protecting your clients from it anymore.

    This is a no-brainer.

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