Relying on the traditional methods for determining a client’s tolerance for risk can be risky in itself, according to Michael Kitces, speaking at the 2014 NTSA 403(b) Summit in Washington, D.C., on June 24. Kitces is a partner and director of research at the Pinnacle Advisory Group.
Putting a client into a high-risk equities portfolio simply because he has a long time horizon and a need for income, without considering how he perceives the risks he’s taking, may be setting him up for failure, said Kitces. Three factors need to be considered:
- Risk capacity: the client’s time horizon and need for income, the availability of other assets and knowledge level of investments.
- Risk perception: how risky the client thinks his investments are.
- Risk attitude: basically how the client would respond in a down market; would she leave the portfolio alone or would she panic?
Risk capacity measures how much risk a client can afford to take or needs to take to achieve his goals, Kitces noted. Risk attitude establishes the upper level of the amount of acceptable risk. And risk perception connects the client’s evaluation of whether the implemented portfolio is consistent with the client’s risk attitude, which will require constant tuning and management and should be part of the financial planning process.
It’s the client’s risk perception rather than his tolerance that fluctuates with the market, and risk perception will often depend on recent market activity. People tend to expect bull markets to last forever and for bear markets to be the end of the world, Kitces observed.
A combination of well-designed questionnaires and conversation can help determine a client’s range of perceptions of risk. Positioning his portfolio too close to his actual maximum tolerable risk means that his range of perception may even veer into excessive risk territory, resulting in panicky phone calls from the client and impetuous investing behavior.
“It’s not risk tolerance that swings with bull and bear markets,” said Kitces, “it’s risk perception. You can’t manage risk tolerance, but you can manage risk perception. It’s important to understand the difference.”
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