This has been a rocky year for investors and 2020 still has several months to go. The economic fallout from COVID-19 has impacted the stock market in a big way. We’ve seen the market reach all-time highs in February only to drop precipitously into March.
The markets have rebounded nicely since then. However, it’s been a bumpy ride, and nobody knows what the future holds over the next few months with the continued virus issues and the election coming up in November.
You have probably done a risk tolerance assessment of your clients at one point or another. Given all that’s happened, this is a good time to assess or re-assess your client’s risk tolerance.
Reacting to Market Volatility
An informal insight into a client’s risk tolerance is how they react to volatile periods in the stock market. Have they generally been calm during market volatility in the past, but have been more concerned about the volatility this year in the wake of the COVID-19 pandemic? Perhaps their personal situation has changed during the pandemic due to a job loss or a furlough.
Even clients who may seem calm outwardly may be feeling stressed about the volatility of the markets and the impact of the pandemic on the economy. Every client is a bit different in how they deal with stress. If you aren’t sure how your client is feeling about market volatility, ask them. Even clients who seem the most immune to feeling anxiety regarding their investments might become more affected by concerns over their investments over time.
Defining What Risk Means
Risk will mean different things to different people. What’s important is what it means to your clients. It’s not just investment returns. Investors may view risk in terms of how market losses may impact their ability to achieve their financial goals like retirement or paying for their children’s education.
Beyond knowing what risk means to their clients, it's important for advisers to help them understand other types of risk they could face. A good example of this is inflation risk. Clients might be inclined to move away from risky assets like stocks in the wake of a market correction or economic weakness to mitigate the risk of loss.
For all clients, but especially for those in or nearing retirement, the risk of inflation eroding their purchasing power is potentially more devastating than the risk of temporary losses from a market correction. This is an important conversation to have with clients, whether for the first time or as a reminder of why it's important to balance the risk of loss on their investments with the potential for the appreciation that they need to help ensure they don’t outlive their assets in retirement.
Financial Goals and Time Horizons
A key factor in assessing a client’s risk tolerance is their time horizon. When clients are younger and have a longer time horizon until they need the money, they shouldn’t pay much attention to the gyrations in the markets.
As they get older this may change a bit as they realize they have less time to make up for any significant investment losses. It’s with these clients that advisers need to stress the need to balance downside risk with the continued need for appreciation from their investments. The client’s asset allocation should be evolving to reflect their age and the need for the right balance.
The Benefits of Asset Allocation and Diversification
It’s important for advisers to emphasize (or perhaps reemphasize) that a properly diversified portfolio is one of their best weapons to fight risk. This is where asset allocation comes in. While it certainly doesn’t eliminate risk, it can help keep your client’s risk within acceptable parameters.
In setting their initial asset allocation and in subsequent revisions over time as their situation evolves, illustrating the relative level of risk they are taking against an appropriate benchmark can help. However, it's important to take it a step further and relate this to what it all means relative to the achievement of their financial goals.
Managing the level of investment risk taken on by clients is an ongoing process. It's important for advisers to assess and reassess their client’s risk tolerance to ensure that your advice is consistent with their comfort levels.