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aaron klein co-founded nitrogen and led the company to 42 straight quarters of growth as its first ceo. he was named by investment news as one of the industry’s 40 under 40 executives, and the wealth management industry awards honored him as ceo of the year in 2023. |
the key is reasonable expectations.
by aaron klein and dan bolton
the holistic guide to wealth management
we face risks every day in our lives, from getting into our cars, to eating meals prepared at a restaurant, to flying in planes, to attending parades, sporting events and concerts. rather than burying our heads in the sand, most of us get on with our daily lives by making calculated assumptions about what risks are safe and manageable and which ones are reckless.
when it comes to our money, however, risk plays all kinds of games on our emotions and often triggers our fight-or-flight response. the securities & exchange commission defines financial risk as “the degree of uncertainty and/or potential financial loss inherent in an investment decision.” in general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.
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dan bolton is vice president of corporate marketing at nitrogen. he is the creator of the fearless investing summit, one of the most dynamic and well-attended conferences in the wealth management profession, and launched the pre-eminent benchmark advisor growth survey. |
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so, if you’re thinking of adding an investment advisory component to your accounting practice, just know that being crystal clear about each client’s unique tolerance for risk is the first step toward getting them invested properly.
what is risk tolerance?
risk tolerance is an investor’s ability (and willingness) to endure market fluctuations and potential losses without abandoning their investment plan. it’s a complex interplay between their financial goals, their investment timelines and their personal experiences. it comes down to each client’s psychological comfort with uncertainty and no two people have the same tolerance for risk, regardless of their age, gender, occupation or financial upbringing.
for starters, the traditional age-based parameters for determining how much risk a client should have in their portfolio no longer cuts it. for instance, macro data shows that more than half (52%) of 20-somethings are not “aggressive” investors and more than half (53%) of 70-somethings are not “conservative” investors. so, it’s dangerous to build cookie-cutter portfolios for clients based solely on their age. again, you must really get to know them first.
“the biggest risk is not taking any risk … in a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks.” – mark zuckerberg
while many clients will tell you in initial meetings that they have a decent tolerance for risk, it really comes down to how far their portfolio can fall before they capitulate and make a fear-bound decision such as selling all their stocks and moving into cash or treasury bonds. it’s the equivalent of folding in the game of poker, without being able to see your hand of cards (a.k.a. the future)!
but understanding a client’s risk tolerance is only one part of the advice equation. you must also determine their capacity for risk in order to help them reach their goals. risk capacity refers to how much room an investor has within their assets to absorb losses from their investments without jeopardizing their financial goals or stability.
we discovered early on that far too many financial advisors were stereotyping clients based on their age, and those investors had far more risk in their portfolio than they wanted – both from a risk tolerance and risk capacity perspective.
but we also saw many of their clients sitting on the sidelines and not understanding how a longer time horizon could give them a strong risk capacity. advisors weren’t taking the time to help them get comfortable with a higher degree of risk to achieve better returns.
it’s really about looking at each client holistically. how much risk do they need from their investments to reach their financial and life goals?
understanding risk in this way is very important for cpas. you may be interested in offering wealth management services to clients but are afraid of losing those clients following a bad year in the stock or bond markets like we had in 2022. it’s all about reframing client expectations.
how to reframe client expectations
if the risk conversation isn’t adequately communicated, a market downturn can leave clients distressed and questioning their investments. conversely, during a bull market, clients whose portfolios don’t mirror the market’s rapid growth may feel they are missing out on significant returns. both scenarios underscore the importance of clear and consistent communication about risk and expectations to maintain client trust and satisfaction. that’s where the risk number comes in. more on that in a minute.
when the market gets choppy, skeptics will say your clients have the wrong amount of risk in their portfolios. that’s when the phone calls coming flooding from nervous clients asking: “are we going to be ok, or should we move to cash?” meanwhile, during an unexpected bull market like we saw in 2023, those same clients call in asking: “why am i not beating the market?”
that’s where a proper risk conversation comes into play. clients just want to know what’s normal for their portfolio. that’s where it’s important to frame the conversation around a six-month 95 percent range. that range is the likely span of gains or losses a portfolio might experience over a six-month period within a 95 percent confidence interval, i.e., within two standard deviations of the mean.
for instance, over the last 30 years, the stocks/bonds 60/40 portfolio achieved an 8.05% compound annual return, with a 9.63 percent standard deviation. in other words, you can tell clients with confidence that given their asset allocation and risk parameters, 95 percent of the time their 60/40 portfolio would be expected to return 8 percent +/- 19.25 percent. that’s a likely range of between +27.25 percent to –11.25 percent. going back to 1986, there was only one year in which the 60/40 portfolio met or exceeded +27 percent (1993) and only four times when it returned less than -11 percent (1990, 2002, 2008, 2022; see chart below).
the 5 percent left over is a statistical standard of downside risk that can’t be quantified (black swans, unforeseeable market events), and it represents a “devastating loss” for the client. however, after thorough testing in different market environments, less than 1 percent of portfolios have actually dipped into that 5 percent devastation range.
the 5 percent outlier range is something we can’t control, but the 95 percent interval is something that we the advisor can control. our research shows that setting expectations that way helps investors hang in there even when the markets are volatile.
stress test
the other question clients often ask is: “why isn’t my portfolio beating the market?”
more often than not it’s because they’re not taking on as much risk as the overall market, or their risk is misplaced into the wrong type of assets. that’s where a portfolio stress test can be helpful.
just as banks must have regular stress tests of their reserves and capitalization, investors and retirees can have their portfolios stress-tested to see how their plans might hold up under challenging financial conditions. for instance, our firm has models that simulate how a client’s portfolio would hold up designed to stress test clients’ portfolios under the 2008 bear market, the 2009-10 global financial crisis, 2022 inflation and the recent interest rate spikes. each stress test shows the advisor the date range used to build the scenario, the historical performance of the s&p in that timeframe, plus what the client portfolio is likely to do if the same market conditions occur.
control risk vs. beat the market
every investor wants to beat the market, but many don’t want to experience the stomach-churning highs and lows that come with being fully invested in equities (i.e., risk assets). whether they know it or not, every investor has a sweet spot between how much they want to earn from their investments and how much risk they’re willing to bear in order to get there.
financial theorists call this the “efficient frontier.” our firm takes the efficient frontier a step further by assigning a specific “risk number” to each client (on a scale of 1-100) to show them precisely how much risk they can handle.
when people hear the tv pundits talk about the market, they are usually referring to the s&p 500. someone who aims to track the broad-based s&p 500 index has a higher-than-average risk score of 78 on a scale of 100. a client who has a more modest risk score of 52 is never going to beat the s&p 500 because they can’t stomach a risk level in the 70s or 80s – a risk level that’s reasonably needed to match the overall market. on the flip side, when we have severe market corrections like the global financial crisis of 2008-09 or the pandemic of 2020, they won’t lose nearly as much money as investors with much higher risk scores. by using specific risk numbers and the visuals below, it becomes much easier to educate clients about their risk tolerance and hence set reasonable expectations of returns.
for instance, you can show a risk-averse client that the s&p 500 is a risk number 78, and their risk number 52 portfolio won’t make as much when markets are up. that helps answer why they’re not “beating the market” during a bull run. but they’ll be comforted when the bear market returns and they can see they’re losing a lot less money than more aggressive investors are. by using the risk number as a guide, they’ll remember exactly why they’re a 52 – clients just “get it.”
what if 2008 happened again?
you know better than anybody else that clients want to know what’s “normal” for their portfolio. and you also know that setting expectations based on “average” returns doesn’t work – after all, the market almost never hits its own average!
stress tests give you preset market scenarios to illustrate hypotheticals with your clients. these examples are not only powerful for illustrating how you’ve built a portfolio (maybe it’s fortified from interest rate spikes), they’re also a game-changer when it comes to reinforcing how you set a client’s expectations.
prospect theory
now that we have introduced you to risk tolerance, risk capacity, expected returns and stress testing, it’s time to move beyond the technical aspects of your job and to understand the equally important behavioral aspects of your job. that’s where prospect theory comes in.
prospect theory is an academic framework that won the nobel prize in economics in 2002. it incorporates psychology into economic models and examines aversion to risk through a behavioral lens. decades of academic research is empowering better decision-making today.
historically, academic studies had taken a prescriptive approach, focusing on how decisions under uncertainty should be made. prospect theory instead takes a descriptive approach, focusing on how people actually make decisions under uncertainty.
one of the core principles of prospect theory is that losses tend to have a more significant impact on people’s psyche than gains do. first, individuals make choices to minimize losses, more than they gamble to make gains. in one experiment, four out of five respondents preferred to have the 100 percent certainty of receiving a $3,000 gain to an 80 percent chance of a $4,000 gain, if that 80 percent chance came with a 20 percent chance of receiving zero. however, when faced with the same two negative potential outcomes, 92 percent of respondents preferred to gamble on an 80 percent chance of losing $4,000 (and 20% of losing nothing) to a certain loss of $3,000. in both cases, respondents chose the option with the lower expected return in order to avoid losses.
our firm took prospect theory out of academia and expanded it into a practical and effective tool for measuring a person’s true risk preference. our risk number technology takes into account two important factors:
1. an investor’s actual financial position and
2. what constitutes a “devastating” loss or an “acceptable” gain to them.
when individuals make choices based on their actual financial position, there are real consequences for the decision maker. this is one of the ways risk assessments can be used. it’s not just about a dollar amount; it’s an amount that is both specific and meaningful to the investor.
for billionaire warren buffett, investing $100,000 in a new tech stock is pocket change. he could afford to lose his entire investment and would barely feel the impact of that loss. however, a family investing their entire net worth of $100,000 into that same stock would be devastated if the company went belly up. that’s where risk preference plays a vital role in keeping individuals invested for the long term.
promoting positive client behavior and long-term outlook
by aligning investment strategies with clients’ long-term goals – for example, retirement readiness, funding education or transferring wealth – advisors can steer their focus away from short-term market perturbations and place it instead on helping clients achieve their ultimate financial objectives. reinforcing this mindset requires regular client reviews that assess progress toward their long-term goals.
conclusion
portfolio recommendations require quantitative measurements and asking as many questions as possible to gauge inconsistencies. other risk questionnaires have used hypotheticals based on percentages, subjective questions such as, “what kind of car would you drive?” and other strategies that have no actual relevance to investors. our firm took award-winning behavioral finance principles and made them practical. you now have the tools and the science to help clients mitigate risk and invest for the long term.