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With the stock market setting its sights on new highs, is it time for advisors to have another serious conversation about risk?
With all that is going on across the globe—war in Ukraine and the Middle East, persistent inflation, rising interest rates, a looming recession, and a divided government likely headed to another fiscal cliff—the stock market appears to be climbing a wall of worry. But how long can that go on? When will it end?
As the market nears new highs, that is the question being asked with increasing regularity by market analysts, media pundits, nervous investors, and financial advisors alike. While the question is palpable, the answer is not so obvious.
Although no one can answer the question with any degree of certainty, the consensus is growing among advisors that, as market milestones continue to pile up, the next big move is increasingly likely to be to the downside. While no one is in panic mode or heading for the door, many advisors are beginning to re-evaluate investment allocations and consider a range of de-risking strategies. Yet, few are willing to buck this market’s resilience at this point in time.
Preparing clients for the next big move
The more significant challenge for advisors is keeping their clients’ temperaments in check and their eyes on their long-term investment objectives. Still deeply scarred from previous market crashes and the sudden realization that many people would have to delay their retirement, clients may be feeling more anxious about “what’s next” than their advisors.
From the advisors’ perspective, it becomes an issue of preventing their clients from making costly behavioral mistakes, such as panic selling near a market bottom, exuberant buying near a market top, or other ill-timed portfolio changes. A big part of that is ensuring they have appropriately calibrated their clients’ risk-return profile based on a deep understanding of their tolerance for risk. This may be an appropriate time to reassess their clients’ risk tolerance if it hasn’t been done so in a while.
Advisors need a deeper understanding of risk tolerance
According to some studies, it is unlikely your clients’ risk tolerance would have changed much, except for age-appropriate adjustments. The studies show that, over time, investors’ risk tolerance rarely changes, even in the face of significant market events. That’s because risk tolerance, which reflects our attitude toward risk, is considered a psychological trait ingrained in us early on. If true, it doesn’t explain the sudden change in investor behavior during a major market event.
For example, why would a conservative investor with a conservative portfolio suddenly decide to increase his exposure to equities during a raging bull market? Or why would a more aggressive investor choose to unload equities during a steep market decline when, in both cases, their portfolios are appropriately aligned with their risk profile? The studies found that, while their risk tolerance may not have changed, their perception of risk probably did. An investor can have a very stable risk tolerance but an unstable risk perception.
However, other studies have found that, while risk tolerance does vary over time, it is influenced by investors’ perception of risk. The critical point is that financial advisors need to look beyond risk tolerance to understand how much risk their clients perceive at any given time to ensure they are providing suitable advice.
What is your clients’ perception of risk right now?
The perception of risk—how one views his or her portfolio or an investment at a particular time relative to their risk tolerance—can change frequently. While risk tolerance can be easily assessed, risk perception is more difficult to gauge because it is based on subjective factors, observations, and biases that can change over time.
It is also the perception of risk that typically leads to behavioral mistakes. For example, the more aggressive investor, who has a risk tolerance and financial capacity to withstand a 20% decline in the market, may suddenly perceive a market decline as being far worse based on his previous experience in 2008 market crashes or what he heard from a market pundit over the weekend.
The understanding that clients’ risk perception, which is often the catalyst for bad investment decisions, is typically masked by their more stable risk tolerance is especially important as the stock market continues to advance. It’s kind of like the paddling ducks analogy. They may look perfectly calm on top of the water, but they’re paddling like mad below the surface.
A conversation that can’t wait
As the stock market continues to climb, now would be the time to have this critical conversation with clients—to dig deeper beneath the surface to see if their risk perception aligns with their risk tolerance. The conversation is much easier to have now than when they are ready to stampede off the cliff with the herd.
Related: When Markets Are in Transition