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Market volatility: How much risk can you handle?

Nicki Bourlioufas  |  02 Sep 2019Text size  Decrease  Increase  |  
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The current market volatility highlights the need for investors to stay level-headed and stick to their financial plan, even as markets rise and fall. Before making any investing decisions, investors must understand their tolerance for risk so they avoid hasty decision-making if share prices fall sharply.

According to Paul Resnik, co-founder of financial risk experts FinaMetrica, risk tolerance is the heart of an investor’s comfort or discomfort with their portfolio of investments. If an investor is acting within their risk tolerance, they should not experience discomfort as markets swing, provided advisers have appropriately framed their expectations.

But if an investor is acting outside of their risk tolerance, they are likely to experience discomfort or even fear if market sell down, leading them to buy or sell at the wrong times, sealing losses and missing out on future capital gains.

“Investing success is a marathon and not a sprint. We need clients to stay invested through the ups and downs, as if they sell out during the down they miss out on the next recovery. All of the evidence says that the best way to keep [people] invested is to invest them within, or close to within, their risk tolerance,” says Resnik, adding that our comfort with risk is a personality trait.

Brett Evans, who heads up Atlas Wealth Management, says that unless there has been a dramatic macroeconomic change, either domestically or globally, then investors who sell during short-term volatility risk exiting the market at the wrong time.

“If your investing time frame is long-term then you need to be comfortable in the fact that the returns generated by any asset, whether that is property or shares, are not linear and there will be times where prices retrace,” says Evans.

“If you are feeling anxious about your portfolio then you may be investing in the wrong assets or have the incorrect asset allocation in your portfolio. Everyone thinks they like to take on risk whilst the market is rising but should it fall, and you have concerns about your portfolio’s safety, then you may not have as high a risk tolerance as you think,” says Evans.

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It is also important that financial advisers address their clients’ expectations realistically so they are comfortable with their investment allocation through all markets.

“When people hold expectations that are not met they often react radically — say, by selling an investment that has failed to live up to those expectations. It can happen in two ways and advisers are to blame for both,” says Resnik.

“First, it can mean the adviser failed to properly frame and manage the client's expectations — which is an important part of their job. Second, and far worse, is that the adviser was not truthful about what the client should expect and set them up to be disappointed sellers,” he says. 

FinaMetrica measures an investor’s risk tolerance using a psychometric online test. Psychometrics is a blend of psychology and statistics, and according to Resnik, it is the only methodology that is proven to produce valid and reliable results when measuring financial risk tolerance.

“A very dramatic life event can change risk tolerance, and you never quite know what has been happening in the background of your client's lives. Age can also see a reduction in risk tolerance at time, but most people will remain the same,” says Resnik.

Evans says measuring risk tolerance also involves observing clients’ behaviour over a period of time.

“Measuring risk tolerance is almost impossible to perfect as there are too many variances in opinions. There are standardised formulas that you can use. However, this will only do 60 to 70 per cent of the job. It is actually time in the market that will provide you with the answer for the remaining 30 to 40 per cent.

“If you have invested the same way for the last two, six or 10 years, and even with the volatility that we have seen, you are still comfortable, then you know you have invested your funds appropriately,” says Evans.

The well regarded CFA Institute believes risk tolerance is a personality trait and should be remeasured as circumstances change. In a recent research paper, Elke U. Weber and Joachim Klement say risk attitude seems to be a stable psychological trait of an individual that can be assessed with the appropriate tools, such as a psychometric questionnaire or a general risk-attitude question, which asks participants to assess their own willingness to take risks. 

“The reviewed literature shows that risk attitudes, properly defined, are more or less stable throughout an investor’s lifetime. These studies also show, however, that an important second determinant of risk aversion or risk-taking is driven more by circumstances than by traits.

“Recent market events and investors’ lifetime experiences do influence investment decisions because they change the perception of risk. Financial advisers need to regularly assess these changing risk perceptions in order to provide the best possible advice for their clients," say Weber and Klement.

 

is a Morningstar contributor.

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