By Mike McDaniel, Co-Founder and Chief Investment Officer
An investor’s risk tolerance is unique. With the Risk Number?, an advisor can quantify their client’s risk preferences and tailor a portfolio to match. Having just the right amount of risk means that clients are set up for long-term success, but can an investor’s Risk Number change? How often should an investor’s Risk Number get an overhaul, if at all? We wanted to share some best practices we’ve learned over the past few years of monitoring investor Risk Numbers so you know the possible signs of a risk intervention.
Major Life Events
A reassessment of an individual’s Risk Number may need to occur after a potentially impactful life event, such as divorce, death, job loss, inheritance, marriage, etc. These events may have a lasting impact on a client’s financial position, and the position of their beneficiaries, for many years to follow.
The Risk Number is generated by a number of factors, one of which is the investor’s actual financial standing. Major life events that affect an investor’s net worth, either up or down, have the potential to create a risk shift.
Example
Edward passes away unexpectedly and leaves the entirety of his estate to his brother, Harry. This one event (a death in the family) has a series of consequences: Harry’s doubled net-worth, the effect of these assets on his retirement projections, and the increased size of his estate in the event that something should happen to him, as well. Will he become more risk-seeking or more risk-averse? Harry could use this as an opportunity to decrease his risk exposure, choose to ramp up his risk exposure, or it could have no material impact on Harry’s Risk Number whatsoever. Harry could think, “I’ve got enough assets to surely see me through retirement, there’s no need to change course.” Or Harry could think, “This is a windfall I wasn’t expecting, and I could risk it all with no extreme negative impact on my retirement.”
Best Practice
Re-administer an exercise or initiate a discussion when a material financial event occurs in an investor’s life. Be sensitive to their experience and quantify their updated perspective when they’re ready.
Nearing Retirement
As the retirement horizon approaches, priorities may begin to shift. Planning for retirement is a very different animal than living it, and a reevaluation could ensure that targets are still on track.
A person’s Risk Number may not be affected by impending retirement, but their risk capacity (the amount of risk they’ll need to take to reach their goals) could require attention. A client may need to take advantage of IRS “catch-up” rules so they can make greater contributions to retirement accounts, and emotionally, it’s difficult for some clients to shift from “amassing” wealth to “spending” it.
Example
Thomas and Nancy Smith plan to retire at 60. They originally planned to downsize their home, but the home’s sentimental value is giving them second thoughts about selling. Without the proceeds from the home, is their target retirement date in jeopardy?
Best Practice
A check-in with a client near retirement is a way to make sure that their goals are still attainable at their current risk level. In the example of Thomas and Nancy Smith, an advisor can reassess their risk capacity and see if taking advantage of the IRS rules, maxing out their account contributions, or delaying retirement are valid options.
Stable vs. Unstable
Investors are either stable (rational) or unstable (emotional). Stable investors will likely have stable Risk Numbers over the course of years, whereas the Risk Number for more emotional clients may swing a bit over time, depending on several factors. Advisors need to be attuned to the psychology of their clients and be flexible enough to change course.
Example
John owns his own small business and has children in college. Recent market events have him very worried and he’s reaching out to his advisor frequently for reassurance. John’s business is experiencing an especially slow off-season, and he’s concerned about tuition costs rising, but he hasn’t experienced any significant changes in his wealth. When his business is doing well, John doesn’t call or respond as often to check-ins from his advisor.
Best Practice
Advisors use Check-ins inside of Nitrogen to identify which clients fall into the stable or unstable category. Typically, a stable investor will have consistent answers through time as collected using Check-ins or regularly administered risk assessment processes. Sporadic responses to Check-ins over time could indicate a more emotional client. That’s helpful intelligence for an advisor. Advisors would do well to confirm Risk Numbers with their emotional clients regularly (semi-annually), whereas the more stable clients may not need a reassessment but annually, or only after a major life event.
Our process is amount-driven.
Risk isn’t based on stereotypes or market sentiment. It’s rooted in an investor’s psychology, aversions, and financial position. In situations where a major life event occurs, it can impact all three.
Nitrogen’s use of meaningful dollar amounts specific to each investor expanded behavioral finance principles. Our inclusion of actual dollar amounts (rather than projections, percentages, or estimates) is an important one. Because these dollar amounts are foundational to the calculation of an investor’s Risk Number, it suggests that we can update their risk preference as life unfolds.
Do people change?
Over the past 12 years and through significant financial challenges, wild market events, and life changes, my personal Risk Number has remained unchanged (I’m a Risk Number 34). Generally speaking, we’ve not seen Risk Numbers gyrate due to market environments or “news.” That said, advisors may want to reassess Risk Numbers (especially of emotional clients) when a meaningful change in market or news conditions arise. And, I should note that the Risk Number helps confirm or combat an advisor’s assumptions concerning how they might expect a client’s Risk Number to change given the life events.
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