by Aaron Klein, CEO
Human nature is against us. Advisors are no strangers to the idea that investors naturally have a tendency to buy when things are good, sell when they get scared, miss the recovery, buy back in when the markets “feel safe again,” and repeat until broke!
In an ongoing attempt to combat this, the financial industry has evolved significantly over the past several decades. The trends we've witnessed can be categorized into what I call the three waves of advice.
1. Focusing on Returns.
It's the 1980's. Markets are booming. Investors are anxious to find the best broker, and brokers are hungry to onboard new investors. Commissions are high, and new reps flock to the profession continuously.
With so many options, what incentive does an investor have to choose one broker over the other? It all came down to the broker's promises, of course.
“My mutual fund is way better than that guy’s mutual fund.”
The first wave of advice died abruptly with the discovery of an unfortunate fact: His mutual fund actually wasn't better than that guy's mutual fund.
2. Long-term Goal Investing.
Performance promises weren't a viable way to set expectations for investors. That sobering realization led us into the second wave of advice.
"Let me distract you by talking about your long-term goals."
Now, before I'm flooded with angry emails about my thoughts on the second wave, let's get something straight – it's wise to consider the long term. No decent advisor today would undervalue the ultimate future of a client's financial health.
The issue here isn't that we focused on the long-term, the issue is what got ignored. Many advisors began disregarding human nature altogether. This works about as well as your doctor saying "If you exercise now, you'll thank yourself in 30 years."
The pendulum's overcorrection caused many advisors to begin ignoring returns completely. We began ignoring risk, ignoring human psychology, and focusing only on the long term. The problem is, this simply doesn't work.
All of our research points to a simple truth: while investors should be focused on the long term, they react to risk in the short term, and emotional reactions to risk are the number one killers of long-term financial goals and results.
3. Putting Risk First.
Advisors have since become savvier in the behavioral coaching realm. The industry has woken up to the idea that the short term matters. It's why we define risk tolerance like this:
“How far can a portfolio fall, within a fixed period of time, before the investor will capitulate and make an emotionally-charged, poor investing decision?”
We're witnessing the third wave of advice: putting risk first. When advisors quantify risk alignment from the start, they set clear expectations for investors. A clear understanding of risk and returns can allow investors to give themselves permission to "hang in there," even if markets are volatile.
The third wave of advice is catching on more quickly than we could've ever imagined. We're seeing it firsthand. When you quantify risk for an investor, you can empower anyone to invest fearlessly.
Aaron Klein is CEO at Riskalyze, the company that invented the Risk Number and empowers advisors to align clients with their portfolios and expectations.