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Written by: Dave Alison
As a financial advisor, one of your primary and most important functions is to counsel your clients on staying the course with the investments that are best suited to their long-term financial goals. But how can you be sure that your client will be comfortable with and accept your recommendations? Will they be able to withstand the natural ebb and flow of the market over the years? We know that they go up and down like a roller-coaster sometimes, but these days the ride is even more turbulent than ever before. This is where a Volatility Tolerance Analysis can be an invaluable tool for both advisor and client.
Although measuring your client’s volatility tolerance is valuable for clients of any demographic, it becomes a larger issue post-retirement, according to Wade Pfau, Ph.D., CFA. In The Changing Risks of Retirement, he states that “Retirees have less capacity for risk as they become more vulnerable to a reduced standard of living when risks manifest. Those entering retirement are crossing the threshold into an entirely foreign way of living.” He goes on to list the risks that retirees can face, including:
- Reduced earnings capacity
- Visible spending constraints
- Heightened investment risk
- Unknown longevity
- Spending shocks
- Compounding inflation
- Declining cognitive abilities
Many retirees will struggle with the new constraints of a fixed income and many unknowns – the rising cost of living, their health, and market volatility, to name a few. In many cases, advisors will find themselves dealing with the tug-of-war going on in the client’s mind: their cognitive bias toward investing versus their emotional bias. In other words, what the client thinks and knows about the risks in their investments and what they feel about them. An example would be a client who went through the Great Depression and is now retired. When allotting their funds to various investment vehicles, they know that a certain high-risk investment is a good choice for their long-term money; but what they feel is that their money would be safer under their mattress at home.
Studies have shown that demographics can influence a person’s risk tolerance, as well. In his paper An Empirical Analysis of Financial Risk Tolerance and Demographic Features of Individual Investors, Dr. Ebrahim Kunju Sulaiman concludes that while financial tolerance does not necessarily decrease with age (a common belief), there is a correlation between risk tolerance and marital status, and the level of formal education. So many different factors go into risk tolerance, and every client will be unique, with different backgrounds and experiences, that simply using age or years until retirement to guide your recommendations will not be enough.
The Volatility Tolerance Analysis & the Bucket Plan®
When gauging a client’s volatility tolerance, it is extremely important that you educate them on the three principles of sound investing to help them understand why you are recommending that they invest their assets in a certain way.
Time horizon segmentation – Determining an appropriate time horizon is one of the foundational elements of successful investing. A client’s time horizon in relation to when they will need to access their money will impact their tolerance for risk or volatility. If you are bucketing money, each bucket will have its own time horizon and associated risk profile.
Risk tolerance – After you have time-segmented the client’s assets, you can now overlay a risk assessment or volatility tolerance analysis on top of each bucket. Within the context of The Bucket Plan®, the investment philosophy that allocates funds to “Now,” “Soon,” and “Later” buckets, the Volatility Tolerance Analysis measures the amount of volatility that a client is comfortable with in their Soon and Later buckets (the “Now” bucket is cash in the bank, so no risk assessment is needed on that bucket). And because each bucket has a different purpose and time horizon, the two buckets are scored separately – a client may have a higher tolerance for risk in their Later bucket, for example, because there is more time for the market to correct itself from a downturn. By segmenting first, you’ll get a clearer picture of the behavioral reactions a client will truly have regarding their accounts.
Diversification – Once you have time-segmented the money and added a risk assessment to each segment individually, you’ll have the knowledge you need about your client’s behavior mindsets to build the proper asset allocation strategy to achieve diversification. By spreading the client’s assets across a variety of investment vehicles and markets, you will help add protection from concentration risks in certain market segments. That way, if one segment takes a nosedive, the damage to the client’s assets is minimized and they are comfortable enough to stay the course.
When you combine these three essential elements – time horizon segmentation, risk assessment, and diversification – you can eliminate a major risk that hurts many investors: freak out risk. Freak out risk occurs when markets become volatile and the investor makes decisions that can hurt their long-term objectives. Study after study has shown It to be one of the main reasons that the average investor typically underperforms indexes.
Here are some examples of other risk assessment questionnaires that can be found when searching the web, or that a client might use in conjunction with a robo-advisor:
- Charles Schwab – Investor profile questionnaire with seven questions between time horizon and risk tolerance but lacks risk capacity. It provides a suggested investment strategy, but there is no distinction between short-term and long-term investments.
- FinaMetrica and Riskalyze – Give a more in-depth risk assessment score based on stress testing, but still only provides one overall portfolio risk number.
An Advisor’s Guide to Implementing
Before you determine the client’s volatility tolerance, you need to uncover their goals and time horizons for each bucket. This is obviously geared toward each person’s specific circumstances. The Now bucket should cover their planned expenses and emergency fund for the first year or two of retirement. These funds are not invested but are readily available as cash when needed. The Soon bucket is more conservatively invested money and buys a time horizon so that funds segmented into the Later bucket can be more aggressively invested and free to ride out the ups and downs of the market. When the client understands how each bucket will work for them, you will have a much easier time assessing their risk tolerance for each.
The Volatility Tolerance Analysis as part of The Bucket Plan is unique in that it measures a client’s capacity for risk, not just their comfort level. That’s why separating the scores for the Soon and Later buckets is so important. The clients know exactly what each portion of their money is doing for them and why, providing a level of security in their investment decisions. Most risk questionnaires and software only give an overall score along with a generic portfolio allocation strategy, but they don’t address the individual objectives and risk tolerance for each segment of money.
It is extremely important that you fill out the Volatility Tolerance Analysis with your clients so you can have an open conversation and answer any questions that the client might have regarding the questions. This will alleviate any confusion that they have and allows them to provide accurate responses.
It should be noted that the assessment is purposely worded to be product and portfolio agnostic so that an advisor is not pigeonholed into a recommendation that might not be in the client’s best interest. For example, many assessments are more geared to investment products over insurance products, but the reality for many retirees is that annuities could be vital to optimizing their retirement. The result of the Volatility Tolerance Analysis is that the advisor and client will mutually agree upon a risk category for each time segment of money, and then the advisor will use their discretion to select product or portfolio solutions that best aligns with the risk category as well as the financial objectives of their client.
Once the plan is devised and implemented, the advisor should review the Volatility Tolerance Analysis with the client on an annual basis to make sure that nothing has changed, like major life events, upcoming income distribution needs, etc. This is also a good time to review each bucket’s investments and rebalance as necessary to reflect any changes in the client’s risk tolerance. As you are meeting with your client, simply ask them “Based on the last time we completed our Volatility Tolerance Analysis, you scored stable in your Soon Bucket and growth in your Later Bucket. Do you still feel that is an appropriate amount of volatility based on your circumstances today?” You can illustrate the point by showing them how their portfolio performed in relation to the amount of risk they assumed.
The Volatility Tolerance Analysis is just one of the tools that should be used when building a client’s financial plan, but it is an important one in helping the advisor understand any concerns that might otherwise go unheard. Failure to use this or a similar tool will more than likely result in a recommendation that does not initially meet the client’s needs, potentially resulting in additional work and an unhappy client.
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