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Delaware Statutory Trusts (DST) and Alternative Investment News

Knowing If You Can Stomach the Next Big Market Swing
 
September 6, 2019 – The Wall Street Journal

 If I ask you in a questionnaire whether you are afraid of snakes, you might say no. If I throw a live snake in your lap and then ask if you're afraid of snakes, you'll probably say yes—if you ever talk to me again. Investing is like that: On a bland, hypothetical quiz, it's easy to say you'd buy more stocks if the market fell 10%, 20% or more.

In a real market crash, it's a lot harder to step up and buywhen every stock price is turning blood-red, pundits are shrieking about Armageddon and your family is begging you not to throw more money into the flames. Then risk is no longer a notion; it's an emotion.

That is why you, and your financial adviser, should be wary of risk-tolerance questionnaires meant to figure out how much money you will need when, and how willing and able you are to withstand losses along the way.

Unfortunately, imagining your future behavior isn't as easy as it seems. And new research shows financial advisers create drastically different portfolios even when clients appear to have the same tolerance for taking risk.

With these quizzes, says Greg Davies, head of behavioral science at Oxford Risk Research & Analysis Ltd. in London, "you're often getting the answer to another question entirely, which is 'How do you happen to feel about risk this morning?'"

So, he says, they yield "very unstable answersthat move about based on what the market is doing or how the client feels."

 

To be fair, many financial advisers don't take these quizzes seriously. Over the years, dozens have told me that they downplay, override or ignore the results.

That isn't necessarily wrong. Some clients may be all too eager to risk money they can't afford to lose. Others fear taking any risk, but lack the income or assets to reach their goals unless they do.

If, however, advisers are treating risk tolerance arbitrarily and inconsistently, then that's a problem. Putting one investor into a risky portfolio and another into a much safer one isn't easy to justify if they both scored the same on a risk quiz.

That's a pattern Amy Hubble of Radix Financial LLC, an investment advisory firm in Oklahoma City, and John Grable, a professor of financial planning at the University of Georgia, find in a study to be published in the Journal of Investing this fall.

The researchers presented dozens of experienced advisers with descriptions of five clients: age, career, income, net worth, housing situation and long-term goals, as well as their scores from a risk-tolerance quiz.

For one client, the various advisers recommended portfolios ranging from a risky 85% in stocks to a timid 100% in bonds. They also suggested wildly divergent holdings for two clients with identical circumstances but slightly different risk scores.

 

"Even very competent advisers, when presented with the same information, don't seem to be using any standard procedure other than following their own judgment," says Ms. Hubble.

That isn't unusual. Professionals in many fields are vulnerable to what the Nobel prize-winning psychologist Daniel Kahneman calls "noise," or variation in judgment driven by such irrelevant factors as emotion, time of day or the weather.

 

To do better, think about how your past experiences might shape your future expectations.

Joachim Klement, an independent analyst in London, suggests superimposing a timeline of your key financial experiences onto a chart of stock returns and interest rates. Did you buy your first stock at the beginning of a bull market? That could skew you toward taking more risk. Did you start a business during a recession? That could make you more gung-ho if it thrived or gun-shy if it failed.

The best guide to whether you will dump stocks in the next financial crisis is whether you did in the last one. If you weren't investing in 2008-09, look back at the fourth quarter of 2018, when stocks lost nearly 20%. Be sure to ask what your financial adviser did in past market plunges, too.

Your perceptions of risk are only part of the puzzle. At least as important is your risk capacity. Think of your spending habits, your non-financial assets and how easily you could sell them in a pinch.

Also vital are your goals. You can't know how much risk to take until you estimate when and how much you'll need to spend in the future.

Any good adviser should devote more time to your risk capacity and your goals than to your risk tolerance.

Ask advisers to take the same quizzes and make the same revelations as you—and explain how their views will shape your portfolio.

"Clients have biases, but we advisers need to be cognizant of our own biases," says Ms. Hubble, "because we are also human."

 

 

 

 

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