Skip navigation

An Ear for Risk

Although most investment professionals are comfortable explaining the market fluctuations that may affect a clients portfolio, some industry observers believe that few reps are actually educating their customers about a tougher subject--the possibility of a real, sustained drop in the market. For your protection as well as for clients, the topic should be approached openly and honestly.One of the

Although most investment professionals are comfortable explaining the market fluctuations that may affect a clients portfolio, some industry observers believe that few reps are actually educating their customers about a tougher subject--the possibility of a real, sustained drop in the market. For your protection as well as for clients, the topic should be approached openly and honestly.

One of the things that were guilty of--especially in mutual funds--is promoting buying and holding, says Thomas Dorsey, president and founder of Dorsey Wright & Associates, a research firm in Richmond, Va. We tell investors, If you buy it and hold it for 70 years, your average rate of return is 12.5%.

But clients who dont have a lot of time to recover their investments in the event of a downturn--clients nearing retirement, for example--should be managing risk instead of attempting to outperform the S&P 500, Dorsey says.

At their age, they dont have seven and a half years to make up 30% if they get stuck in a bear market, Dorsey says. A broker has to outline what can happen if you get caught up in a bear market or some sudden decline. How long will it take that customer to break even?

Nancy Lininger, founder of the Consortium, a compliance consulting firm based in Camarillo, Calif., agrees with Dorseys assessment. Recent market activity over the last year has shown most professionals have schooled their clients about short-term swings, Lininger says. However, Im worried about a real bear market, which we havent seen for years and years. Thats what investors are not prepared for. If advisers have told them not to worry about short-term losses and market fluctuations, these investors dont know that markets can go down and stay down for a long time.

Au Contraire, Brokers SayNonsense, says Phil Eggers, a Linsco/ Private Ledger rep in Dallas. Although he and many producers concentrate on long-term outlooks, Eggers thinks most full-service brokers are conscientious enough to make sure clients know a bear market is possible.

There are too many old-timers around who tell us to pay cash and dont annualize your best month because this thing can turn around overnight, Eggers says. And most full-service brokers convey that to clients.

Using one of Ibbotsons most popular charts, called Stocks, Bonds, Bills and Inflation (www.ibbotson.com), Eggers shows clients the volatility of the market from 1925 until today. But he makes no apologies for focusing on its long-term potential. He reinforces that vision in quarterly newsletters and seminars.

Im taking flying lessons, and when I come in for a landing, the instructor tells me to look midway down the runway, Eggers says. Theres no way you can focus on the ground directly below you. The same is true in investing, he says. You cant look at this market on a day-to-day basis.

Investors who are educated about short-term drops are less likely to defect if the market suddenly veers downward, says Charles ReCorr, president-elect of the Institute for Investment Management Consultants and a wirehouse producer in Raleigh, N.C. ReCorr has spent three years developing a risk measurement software program (see Calculating Risk Tolerance, below).

Because investors are usually so nearsighted, the software program uses a decision horizon (not an investment horizon) to measure gain potential and risk tolerance, ReCorr says. A decision horizon measures how long an investor will stick with a plan before deciding its not working and bailing out. Most peoples decision horizons are three or four quarters, he says.

If you say to an investor, Over the next 40 years you could make X amount and temporarily be down Y, everyone will make that bet. But then the first time theyre down 90 days in a row, theyre out, ReCorr says. What we ask [in the software program] is, If this investment isnt working, how many quarters before you do something else?

Then, the program calculates the average probable rate of return for that number of quarters and the probable average gain.

In short, using data on the performance of the market and Treasury bills over the past 20 years, the software determines a clients minimum acceptable return. At some point, the client stops looking at potential rewards and starts focusing on potential losses, ReCorr says. Were reframing the clients expectations.

Steve Felton, a rep with American Express Financial Advisors in Rocky Mount, N.C., agrees wholeheartedly. I have always programmed my clients based on historical data, he says. I always underestimate what to expect in a return, because when the investment does better than they expect, theyre excited.

Felton uses asset allocation to explain risk by segmenting a portfolio into income funds, growth funds and balanced funds. He has been emphasizing the fact that recent market returns are well above normal.

The opportunists in this industry can play on yields and returns, but when the going gets tough, the men are separated from the boys, Felton says. Will they return phone calls or will they run and hide?

Everyone knows the market fluctuates. I just got fluctuated out of $4,000! --Jerry Seinfeld in a Seinfeld episode complaining about his brokers explanation of risk

Traditionally, brokers have used two types of questionnaires to measure a clients risk tolerance--informal psychodemographic questions (Do you prefer a red sports car or black sedan?) and more formal questions on asset allocation.

Both have shortcomings. The most common informal questionnaires ask clients what percentage of their portfolio they are willing to risk in order to achieve a long-term goal. They dont ask clients what they think the probability of losing that percentage is, says broker Charles ReCorr, president-elect of the Institute for Investment Management Consultants (IIMC). He has developed a software program for the IIMC called the Investor Risk/Reward Analyzer.

In any questionnaire scoring system, if Im willing to risk 20% and youre willing to risk 10%, Im the risky investor and youre the risk-averse investor, ReCorr explains. But no one asks the second question, What do you think is the chance of that happening?

In other words, although an investor may be willing to risk 20% of his investment, he might think theres only a 1% chance of actually losing that money. On the contrary, the investor willing to risk just 10% of his investment might think theres a 50% chance of losing that money.

In reality, hes the more risk-oriented person, ReCorr says. Although the amount hes willing to risk is less, hes willing to accept a more probable event of risk.

ReCorrs take on risk came after he spent three frustrating years trying to develop a questionnaire that would measure risk tolerance more comprehensively than existing methods. He had a revelation while betting on the Chicago Bulls with his 10-year-old son.

What we need to be asking investors is, Are you willing to take this chance of losing this much in order to make this much? he says. What were asking is, Are you willing to take a 5% chance that in the next 90 days youll be down $3,000 in order to have a 50% chance that after three quarters youre up X amount?

The result is ReCorrs risk-analysis program. For more information about the Investor Risk/Reward Analyzer, call the IIMC at 800/449-4462.

TAGS: Archive
Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish