It may not be easy to understand, but financial advisors consider the subject crucial to the effective management of client relationships. Unless advisors know what their clients’ expectations are and how they will measure investing success, those clients will likely be disappointed.
“People think we’re in the money management business but we’re really in the risk management business,” said Welsford, who has both individual and institutional clients.
Most people think of risk as the potential downside on an investment. But there is a broad range of risks that impact every investor to some degree, and which need to be considered before determining a suitable portfolio of investments.
Do you need income from the portfolio, or will you need to draw from it in the near future? If so, you have liquidity risk. Do you want to retire early? If so, you have longevity risk. Are you in the highest tax bracket? If so, you have tax risk.
“There’s a checklist of risk factors for everyone, and we describe each risk relative to every client,” said Welsford.
The Merriam-Webster dictionary defines risk as the chance that an investment, such as a stock or commodity, will lose value. The greater the risk, the greater the potential loss of value.
Just how tolerant an investor is of losses, however, can be difficult to gauge — particularly if he or she has limited experience with investing. People may say they are un-phased by a 10 percent loss on their investments, and yet a $100,000 loss on their $1 million portfolios terrifies them.
Tim Maurer, director of personal finance at Buckingham and The BAM Alliance, looks at the issue of risk and risk tolerance from three angles: a client’s ability to assume risk, willingness to assume risk and need to assume risk.
People’s ability to take on risk is largely dependent upon the length of their investment horizon. Those in their 20s or 30s have a greater capacity to take risk and recover from large losses than someone approaching retirement. That’s the concept underlying target date funds that allocate more assets to safer fixed income investments rather than riskier stocks as a retirement target date approaches.