Brian Preston and Bo Hanson, co-hosts of the Money Guy Show, share the microphone with Doug, our favorite Money Guy, to discuss why and how should you evaluate, and re-evaluate, your investment risk profile as life changes.
“How much risk can your situation handle?” is a very different question than “How much risk can you handle?”
There’s a significant difference between risk tolerance and risk capacity. Learn what the difference is, and how to adjust your portfolio and emotional expectations for both.
Given enough time, the markets may recover, but do you have enough time in your own plan to recover from potential loss?
While protecting yourself against risk, keep in mind that “today’s dollars” have a different value than “future dollars.” $100 of today’s dollars might not fill your future shopping cart, so plan accordingly.
Are your comfortable with your risk profile?
How much risk can you really stand – answer in real numbers, not percentages.
Which hurts more: losing 10% of your portfolio or losing $50K?
Using dollar figures when calculating your risk profile may make the risk feel “more real” than using percentages.
Make sure to periodically check in with your financial advisor as your life changes. Major lifestyle events (new children, job, marriage, etc.) can trigger the need to update your risk tolerance. So the next time you change your status, make sure to alert your financial advisor, in case an adjustment in your investment strategy is in order.
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Interview With Brian Preston and Bo Hanson
Brian Preston and Bo Hanson, hosts of The Money Guy Show, share their thoughts about retirement, risk capacity and risk tolerance with Douglas Goldstein.
Douglas Goldstein: I’m very excited to have on The Goldstein on Gelt Show, The Money Guy Show hosts Brian Preston and Bo Hanson.
If you haven’t heard of the show, check it out at money-guy.com. Bo and Brian, how are you guys doing today?
Brian Preston: We’re doing great, Doug, and we’re so excited to be on your show. Thank you for inviting and having us on here.
Douglas Goldstein: Yes, it’s cool because the funny thing is that even though I’m in Israel and you are in some other country, we end up doing a lot of the same stuff, right?
You work with people; sometimes we call it financial planning or wealth management. One of the things that I find, even though I’m dealing with people across the border, is that they’re dealing with the same issues.
For example, the market often feels a little bit crazy and people want to take big risks on what they’re doing because they get no interest on safe money.
How do you tell someone that he’s got to begin to protect himself instead of taking big risks when protection usually means low yields?
Understanding Risk Tolerance and Risk Capacity
Brian Preston: There are two elements of investing and people usually understand one of them, but they don’t understand the second one, which is risk tolerance and risk capacity.
We all want to understand that the basic component of investing is you have to take some level of risk. We always try to explain to people that you’ve got to understand your goals, when you think you want to reach those goals, your age, and your capacity to understand and absorb the risk, which is risk tolerance.
Also to get and account for your age, which is that risk capacity, because you don’t want to get in a situation where you swing for the fences and try to get a great rate of return but get hurt.
It’s the other thing that you mentioned, Doug. You don’t want to be so worried about the risk, that you’re so conservative, and that you don’t even reach your goals.
Douglas Goldstein: Tell me what you mean by risk capacity, because to me risk tolerance means, can you stand the pain of watching your money drop? What do you mean by risk capacity?
What Exactly Is Risk Capacity?
Bo Hanson: Risk capacity is how much volatility and how much risk your situation can handle.
The really easy way to think about this is, if you’re someone who’s still in your 20s, 30s, or even 40s, you have a lot of time and you can overcome any sort of financial volatility or hardship.
You work a few more years, put in a few more hours, or whatever the case may be.
As you begin to age, when you get to ages like 50, 60, 70s, you may not have the two, three, four years that it takes for your portfolio to recover value.
We always subscribe to this notion that the markets will recover, but you have to have the longevity where you’re there and have the sustainability where you give it enough time so that it can recover.
Brian Preston: Doug, I’m sure that with a lot of your clients, too, you work with successful people that have a high risk tolerance because they’re business owners; entrepreneurs. You have to explain the risk capacity because it’s a different element than risk tolerance.
Some people can be cowboys in their business life, but as they get older you have to help them protect them from themselves and that ability to take risk, because they might not have the time to recover if they have a bad downturn or have volatility.
Douglas Goldstein: You say that entrepreneurs are big risk takers, but I often think the opposite.
It’s not really the topic of our discussion, but the guys I know, and I count myself amongst them, who are entrepreneurs, tend to be incredibly careful. They think through everything and they’re often very successful, and you figure, “Oh, they must have taken a big risk to be successful,” but that’s not necessarily the case.
They’re just very organized about how they do things, but that is not our discussion.
I want to go back on this risk tolerance thing. One of the types of people that wander into my office a lot is someone who gets an inheritance.
It’s the first time they’ve dealt with money. It could be a big inheritance, and they get $1 million, and I begin to talk to them about risk tolerance and asset allocation and go through the whole story.
The problem is that someone who’s never invested before doesn’t really know what his tolerance is.
How do you teach someone to do that without trial by error?
Teaching Newbie Investors about Risk Tolerance
Bo Hanson: Sure. I think what you have to talk about, especially if you’ve been doing this for any amount of time at all, is some of the experiences you’ve had, maybe through a volatile period.
One thing that we do for anyone who comes in, whether they are highly educated on financial matters, or are just starting out, is we show them certain things.
You look at a swath of diversified portfolios, including very conservative and very aggressive, and how each of those would have performed in an extreme market event like 2008.
We ask them this question: “If you were to hire us right now and you experience this, what in your gut starts to feel uncomfortable? If you saw your account decrease by 15%, 20%, 30%, or 40%, where is your comfort level there?”
Then we show them that exact same portfolio, but instead of looking at it on a one-year basis let’s talk about what it looks like on a three-year, five-year, and even extended basis.
It’s a nice measure of how much volatility they can stand in one year, even though we feel very comfortable that over a longer period it will rebound.
That’s a nice metric for how much risk they can really handle and where their comfort level lies.
Brian Preston: Doug, what we like is using an example. It is not only a great measure for us to take some notes in the background to understand their risk tolerance, but it also is a great educational piece.
We always tell people, it not only measures and it’s not the power of diversification only. But it’s also the power of time, when clients see that it’s not only that one year, it’s the three, or the five.
There’s a reason we tell people the long-term investment horizon is five to seven years at the minimum. Don’t come and invest if you’re saving for a wedding, if you’re saving for a trip for the family, or a downpayment on a house.
That’s not money that necessarily needs to be taking a tremendous amount of risk, if you know you need that money in the next 24 months.
Speaking to Investors in a Language They Can Understand
Douglas Goldstein: We’ve been talking a lot about risk and risk tolerance, and risk capacity, which is a critical idea for people to understand. It’s the idea that you need to know, not just how much you can emotionally stand, but how much risk the portfolio itself can stand.
One of the things that I often try to do is, or one of the things I’ve realized over time, is that professionals often talk in terms of percentages, but the average person doesn’t think that way.
If we say, “Your portfolio might take a drop of 10%,” that doesn’t mean anything to a lot of people because they may not even literally be able to do the math, because it’s just not their thing, or it just doesn’t speak to them.
When I tell a client, “What would happen if you had a million dollars in your account today and next month, it was worth $870,000, what would you do?” All of a sudden they go, “That’s what it means to lose 13%?”
They hear in numbers. I find that the way that you can help someone stress-test his emotions, is by putting real figures.
Sometimes you’ll say, “$130,000. That’s three brand new cars you could buy,” and all of a sudden, that changes the story a little bit.
How do you stress-test someone? How do you help someone to see how much variability he could have in his financial plan?
The Best Case Worst Case Scenario of a Portfolio
Brian Preston: It’s very similar to some of the things that we do. When we do the investment policy meeting with a brand new client, one of the first things we’ll do for them is show them the best case or worst case; the good, bad, and the ugly of the portfolio we’re proposing, plus their old portfolio.
As you know, it’s easy with Morningstar and other software out there to show people how to go back in time and take them back to how they probably felt in 2008 or 2000 when markets were volatile.
We usually say, “Look, this is what the portfolio could do for you in these best as well as worst case scenarios. How does it make you feel?”
You’re right on, Doug. You can get so much information, where if you take the clients, you cannot gauge and understand and comprehend what their reactions are to those decisions, because that’s also going to give you an insight into how emotional they’re going to be the next time there is some volatility in the portfolio.
I think that’s the big value add that a good financial advisor can do. You’re not only just talking about the numbers, like you and I were just talking about.
You’re also interpreting some of those emotional components that are so important for keeping the client on track and establishing and reaching those goals.
Bo Hanson: Doug, another thing that I think is equally important, is talking about what those dollars mean today. Obviously, $1 million 10 years from now won’t be worth the same thing that $1 million is worth today.
Whenever we talk to clients about future retirement income and how they’re going to pay for bills and what charges are going to cost and expenses are going to cost, we always bring those back to the day’s dollars, because it’s much easier to think about in terms of what $100 feels like today versus if that might be $1200 in retirement.
That’s another way to make it seem real for the client - bringing those dollars back to what it would mean if it were to happen today.
Douglas Goldstein: I think that’s a great point. I think you need to realize that money is a very emotional thing.
People make certain money decisions because they are too nervous or too excited, and also because they’re bombarded by advertising, about how much money they can make.
One of the things that I find a lot, especially with retirees, is they no longer even need to make a lot of money. They’ve got pensions and they’ve got enough money to cover their expenses for the rest of their life.
It doesn’t make sense for them to take on risk because if they lose the bet, they’re going to be in trouble, and if they win the bet, big deal.
It just means they leave a bigger inheritance and on top of that, they often can’t even stand the stress.
I think what you guys are both pointing out is the importance of each client understanding how much stress he can handle.
He can then make a wise decision based on the experiences that he’s had, and based on what he sees on paper.
Brian Preston: Doug, I think you have just hit on something that we try to explain. Nobody knows this until they actually walk through that transition in life, from being a worker and using your back, your hands, and your brain to create your income, to then relying upon your portfolio.
You know it because you work with clients and we know it because we work with clients through these transitions.
There is something huge and major that occurs.
The first time you have a downturn or you have a volatile period in the financial markets, when you cannot go back into the workforce, it’s good to have yourself really tied down.
That means having debt paid for, having your asset allocation reflect where you are from a risk capacity and risk tolerance standpoint.
That’s how you protect yourself, because otherwise you are going to realize there is a stress that you never knew existed, when you go into that retirement phase of your life and you rely upon those assets.
You can no longer say, “Hey, I’ll just work a few more years.”
Douglas Goldstein: Right, because it is definitely scary.
Bo Hanson: That’s a key thing and I know you’ve probably experienced that too, as you’ve watched your clients enter retirement, and then you go, “How are you handling this volatility?”
It’s better if you get it right on the front end, by measuring twice and cutting once when you design the portfolio, as well as educate the client.
Douglas Goldstein: Certainly to err on the side of being a little safer. Always better to err on being a little more conservative than being a little more risky. Guys, we’re just about out of time, but in the last few seconds tell me, how can people follow you and follow your work?
Brian Preston: The best way you can reach us is to go to money-guy.com. We are The Money Guy Show.
You can also check us out on Twitter, where you can find us @MoneyGuyPodcast.
Douglas Goldstein: Bo Hanson and Brian Preston, thanks so much for taking the time.
Brian Preston: Thanks, Doug.
Bo Hanson: Thank you.