On Risk Tolerance and Broken Noses

 

From risk systems for advisors to algorithms used by robo-advisors, quant risk management has gone mainstream. These systems have gone from being housed on supercomputers at large institutions to cloud-based systems with calculations that cost almost nothing. However, as cheap risk modeling revolutionizes the way everyone invests, it is important to keep in mind one crucial two-word question: “So what?”
 
Quantitative risk estimation on Wall Street has always been about attempting to hit the right risk level. In a world of wealth management, this is equivalent to hitting the proper risk tolerance for the investor.
 
So as robo-advisors and human advisors are adopting risk management systems they seem to be focused on the risk tolerance aspect of risk system implementation. But risk tolerance is only one of the aspects of the answer to the “So what?” question. The other one must be the reason that an investor wants to take the risk in the first place.
 
After all, nobody really wants any risk; in an ideal world we would get return with no risk (and as advisors know, some investors seem to demand that). Risk taking is our sacrifice in order to achieve our goals. So a risk system that doesn’t directly address the impact on the goals of the investors is leaving out the most important piece of value it could deliver.
 
I like to use car shopping as an analogy to the investing process. When we buy a car we are after certain things like performance, handling etc. In order to obtain things that we desire, we must incur risks. For cars, those are usually measured as crash test ratings from the Insurance Institute of Highway Safety. Let’s imagine what it would it be like to buy a car with a view only to targeting our tolerance for risk and forgetting why we are tolerating risk.
 
Car Shopper: “I am considering these two cars, can you explain to me the difference between them?
Car Salesperson: “Sure thing. The one on the left will give you a whiplash when hit from behind and the airbag will break your nose. The one on the right will actually break a number of bones, including a collar bone and will possibly give you back pain for a good long while. Now, which risks are you ready to tolerate?
Car Shopper: “I’ll take the broken nose please…”
 
It seems absurd, yet something like this happened when risk management systems that were created to target specific levels of risk for institutions began to be used by advisors, human and robo alike. Admittedly, some risk management is much better than none and I commend advisors who are pioneers in using this new technology. But the use of risk management in an advisory practice must rise to the critical next level. It must answer the ‘So what?’ question for the client, i.e., “Why exactly am I incurring this risk. If I am risking a large loss in a junk debt collapse or equity deleveraging, which specific goals am I reaching for? And if I reduce my risk, which goals do I need to give up?”
 
Advisors already answer these questions for their clients. We are simply advocating that they connect financial planning to the rigorous risk management process. Risk tolerance is a very important concept, but it is not the only aspect of risk management. In fact, FINRA’s definition of suitability specifically includes the following:
 
“…customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.”
 
Risk tolerance is one out of ten on this list. While we would agree that its importance far exceeds 10%, it is essential to address objectives, horizon, taxes and the like to truly add value for your clients.
 
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