Risk is back

By Harper Fraze | September 1, 2011 | Last updated on September 1, 2011
6 min read

Advisors now face the challenge of reassessing not only their clients’ risk tolerance levels, but also the nature of risk itself, thanks to the downgrade of U.S. debt to below AAA.

What is risk, anyway? Its definition is troublingly subjective. Some call it the risk of loss. But is this loss of principal? Purchasing power? Opportunity?

Others try to quantify it in terms of volatility. Something changing doesn’t make it risky. That’s just its nature. If we applied this concept to climate and temperatures, living in Canada with our cold winters and hot summers is much riskier than living in Sudan. Also, no one complains when stocks go up. People only fret about volatility on the downside.

My favourite interpretation comes from Warren Buffett: “Risk is not knowing what you’re doing.” This explanation is not limited to investing. It also applies to snow blowers and gas barbecues.

Clients’ risk tolerance

Assessing clients’risk tolerance and managing portfolios according to their comfort level is a central duty for all advisors. The management of risk and suitability is also at the heart of nearly every client complaint and many disciplinary actions by the regulators. As advisors, how do we help our clients respond to this world where risk and safety no longer mean what we thought?

Most firms and many advisors feel a risk-tolerance survey is an essential component of managing their client relationship. Every investment firm has its version, which is often the starting point for configuring a client’s Investment Policy Statement. Other advisors use a less formal process, focusing parts of their discovery conversation on a client’s investment experience and looking for anecdotal evidence of a client’s capacity for taking risk.

Sadly, evidence shows that neither approach works very well. In a 2010 study, Geoff Davey of risk-profiling company FinaMetrica demonstrates industry risk tolerance surveys are deeply flawed and produce widely inconsistent results for clients.

He adds, “Advisors’ estimates of clients’’ risk tolerance are shown to be inaccurate to the point where it would be better if they made no attempt to assess risk and simply assumed everyone was average.” Clients are also terrible at assessing their own risk tolerance. In a bull market, everyone is aggressive. Investors then become hyper-conservative at the bottom of every correction. Investing according to mood swings is a recipe for disaster. Yet, regulators continue to tell advisors they must build portfolios based on a client’s stated risk tolerance.

This is madness. Can you imagine a doctor recommending therapy according to a client’’s stated pain tolerance? “I’m really afraid of needles. I guess we’ll just have to skip the chemotherapy.” That may sound flippant, but this is a serious issue. Recent market volatility is scaring investors out of stocks at precisely the moment when bonds have seen their risk increase. To truly help our clients through this mess, we need to step outside our own comfort zones, take some risk and show leadership &emdash; all while trusting that regulators will eventually provide a more useful and encompassing definition of risk.

What’s low-risk?

What is currently considered a low-risk portfolio has a number of challenges when we look at risk from a retirement income perspective. Bill Gross, the CEO of PIMCO and arguably the world’s greatest bond investor, recently told Morningstar, “Bond investors are not being adequately rewarded for the risks they are taking at the current moment.”

Unless they have a vast amount of money and very modest income expectations, most clients cannot hope to fund their retirement by earning less than 3% on their savings. Moreover, attempting to fund 20+ years of rising costs through retirement on a fixed income is nearly impossible. Consider that a litre of gas cost about $0.57 in 1991. Filling up the family car has gone from less than $30 to more than $65.

Most Canadians are not saving enough to fund their lifestyles into retirement. Compound this lack of savings with an investment strategy that, from the outset, produces a negative return after taxes and inflation, and the plan can hardly be considered low-risk. I’d suggest calling it “no hope” instead.

So what do we do instead?

A more suitable plan for most Canadians is to move out of bonds and into dividend-paying stocks. With a robust and growing stream of tax-preferred income, a diversified portfolio of blue-chip companies has a much greater likelihood of funding a suitable retirement lifestyle and maintaining purchasing power. Dividends can go up; bond coupons are fixed.

The challenge to achieving this additional income is price uncertainty. We don’t know what stocks are going to be worth tomorrow or next year. It is this price volatility that scares investors out of holding precisely those securities they need to own. Excellent advisors teach their clients about the magic of compounding, the miracle of dividend growth and the realities of investment taxation.

In 1987, 2000, 2002, 2009 and today, outstanding advisors are focusing their clients’ portfolios where they have the greatest probability of earning returns necessary to fund their goals. In short, they are doing the opposite of what the crowd is doing.

These are precisely the same people who told investors to sell Nortel in 1999, allocate to gold in 2002, move into emerging markets in 2005 and buy everything they could get their hands on in 2008. I suspect they are curently buying blue-chip multinationals and selling bonds.

While their clients are profiting from their wisdom and judgment, advisors are taking enormous risk themselves. In this instance, I define risk as being a nail when compliance has a hammer. They are doing what is unpopular and unorthodox. Compliance and the regulators view risk as loss of principal; good advisors view it as “loss of purchasing power.”

Consider how you would allocate a portfolio today for a 75-year old widow who has $500,000 and needs $50,000 each year. She states a low tolerance for risk. If you follow current wisdom and invest in GICs and short-term bonds, you have protected her capital from principal loss. However, at 2% rates, she will run out of money by her 85th birthday. Is this really a low-risk option? The primary risk to her capital isn’t the stock market, it’s her debit card. As her daily expenses rise (pick your own inflation number to gauge her burn rate) she’ll have to choose between lowering her standard of living each year or spending her portfolio faster than anticipated.

But if you educated her on her options and showed her how a conservative dividend portfolio that is currently paying 3.5% and has a chance of just 1% annual growth puts her income ahead of inflation, you’ll have truly helped her. This portfolio has a better chance at maintaining her lifestyle for longer. This is a more appropriate option but one that’s unsuitable based on her risk tolerance. Provide this advice and you’ll do the right thing for the client.

There are ways to reduce risk should you decide to advise clients rather than be an order taker:

  • First, be convinced yourself. Take the time to look at the dividend records of the greatest companies in Canada and around the world. Be a student of the market, not a spectator.
  • Identify some simple strategies and portfolios that have a high probability of delivering income growth over the next 20 years. This means being an owner, not a lender.
  • Find and use some basic tools to educate clients on how to manage for capital growth. Show them how investments are taxed and the benefits of a diversified portfolio.
  • Run their retirement numbers. Show them the path they’re on and give them options. Get them to save more and invest with discipline.
  • Document everything. A solid paper trail is your only defence against a complaint and compliance.

This process isn’t for sissies. It’s for professionals. It’s time to remind investors of the fundamentals, not sell them the next managed-yield fund on a DSC. Your clients need advice, wisdom and experience. And they need it right now.

Harper Fraze is a pseudonym. He is an investment advisor with a large, Canadian-based financial services firm he cannot name.

Harper Fraze