JULY 5, 2017
What Advisors Can Learn From One of the World’s Biggest Risk Takers
In May, the Spectrem Millionaire Investor Confidence Index saw its biggest one-month drop in its 13-year history. Almost 40% of millionaire investors said they intend to avoid investing any additional funds in June, which is the highest percentage of investors saying they are staying on the sidelines since December 2013.
Clearly, investors are concerned about the market and believe that staying on the sidelines is the only way to protect their financial futures.
Prudent industry professionals know that attempting to time markets this way is folly, but it identifies a real problem: Advisors may not be doing enough to help investors understand risk and how it affects their financial future.
Risk, and a willingness to take some level of risk, is an essential element of success in virtually any endeavor, not just financial planning. So, we’re borrowing inspiration from one of the most successful modern risk takers, Alex Honnold, the world’s best free solo climber. Just last month, Alex stunned the world when he climbed El Capitan, a 3000-foot vertical rock formation in Yosemite National Park, with absolutely no equipment or harnesses of any kind.
Let that sink in for just a moment: a 3000-foot vertical climb with no equipment or harnesses. Alex is an extreme risk taker. While we aren’t advocating that investors take the same kind of outsize risks with their finances, there are lessons to be learned from someone who pushes the boundaries of risk taking. Alex is able to do so because he has both a specific mental approach and philosophy that guide his actions and allow him to see past the life-or-death circumstances in which he puts himself. Working with advisors, investors may be better able to embrace precipitous conditions and move confidently forward in pursuit of their financial goals.
WWAD: What Would Alex Do?
Take His Time
Alex Honnold did not take on El Capitan on a whim. It took him nine years to work up to this achievement, during which he worked with purpose and patience toward his ultimate goal.
Advisors need to remind investors to do the same. Day-to-day market fluctuations are a distraction from an investor’s actual goal: achieving their personal objectives. Investors often concern themselves with beating benchmarks, but the real risk they face is not reaching their individual goals: wealth accumulation, educational funding or a lasting, comfortable retirement.
So, one crucial role of the advisor is to coach an investor to take their time and think big picture.
Defining a clear financial plan that focuses on elements that investors and advisors can control may provide the best opportunity for success in meeting those long-term financial objectives. On the asset side of the balance sheet, these controllable elements include asset allocation, all costs, tax considerations (where applicable) and the long-term impact of inflation.
On the liability side, the focus should be on formulating a realistic budget for future spending plans, while understanding how current and future capital and income may affect long-term goals. Other considerations include making appropriate use of estate planning, trusts and insurance.
Know His Limits
Even a highly skilled and prolific climber knows he’s not immune to failure. Everyone has limits, which may mean bagging a climb if he’s not feeling 100% or if the weather won’t cooperate. Successful mountaineers are able to distinguish between risk tolerance — what he can stomach — and risk capacity, or what is required to achieve the goal.
In the investment planning arena, we can define risk capacity as a measure of how much risk is required for a portfolio to reasonably achieve its objective. Risk tolerance is unique to each client — it’s how much an individual can stand before succumbing to a rash decision. Different people have different tolerance for negative experiences like the drawdown of portfolio value or perception of market noise. Investors frequently misestimate or conflate their risk tolerance and their risk capacity.
To illustrate, a recent survey by Legg Mason Global Asset Management found that 82% of the surveyed millennials said their investment decisions were influenced by the financial crisis, with 57% saying they were “strongly influenced.” As a result, 85% of millennial investors said they were conservative investors, with 52% calling themselves “very conservative.”
But those who rode out the Great Recession and remained invested consistent with their plan have generally fared well in its wake. People who invested $1,000 in the S&P 500 at the beginning of 2008 and again at the start 2009 were back in positive territory by the end of 2009, according to analysis by financial technology firm CircleBlack. Today, the S&P 500 is up more than 200% since its March 2009 low.
While someone who was extremely close to retirement in 2008 may not have had the risk capacity to ride out the storm, most investors were better served staying in the market. Advisers should make it clear that while being in the market might not feel good when things are going badly, investors may be able to handle more risk than they realize.
Rely on Reason
Another defining characteristic of a world-class climber is emotional control. In any climb one is bound to encounter the unexpected, but often the only way out is up, so you can’t let adrenaline or fear take over.
Investors should do the same. Risk is a necessary component of achieving financial objectives, and we believe advisors need to help investors learn how to take risk in stride and remove emotion from the equation.
Emotion can cause investors to make bad decisions for any number of reasons. Perhaps the sinking feeling of seeing their portfolio go down during a market correction is leading them to want to pull out. Case in point: In the wake of the Great Recession, millennials are one of the most conservative investment groups. Many felt the direct effects of the recession through a difficult job market or saw their parents suffer as they neared retirement. Yet considering their long-term horizon, they arguably have the greatest capacity to accommodate portfolio risk and the most to gain. Staying out of the market is a bigger risk to millennials than the normal ebb and flow of market activity, but they need help to see that and to understand how all portfolio elements work together (in good times and bad) towards long-term financial objectives. Today’s advisor has to be a risk counselor, helping clients understand the big risk picture.
Few of us will ever solo climb a sheer granite wall, but we can all learn from Alex Honnold about how to put risk in perspective when it comes to achieving our goals. Once investors are able to overcome their fear of risk, we think they’ll enjoy the view.