On Risk Tolerance: How Financial Life Planning Can Help Couples Sync Up on Investment Philosophies
When people decide to plan with a financial advisor, they are normally looking to gain financial stability, and growth. Hiring an expert to guide your savings and investment decisions can be considered a safe option that guarantees a bit more control over your future. But part of being a responsible financial advisor involves leaning into the exact opposite of safety. In fact, making the best choices for clients requires a thoughtful engagement with risk. On today’s blog, we wanted to share a bit about how we think about risk, in the markets at large, and especially in terms of understanding our clients’ tolerance of it. A topic that doesn’t get enough attention in this space is how financial advisors can help couples deal with gaps in risk tolerance, so we wanted to go into some detail about our unique approach.
All investments and savings options can be associated with a specific level of risk. Put simply, this is the chance that the outcome of your investment will be different from its expected return. Put even more simply, it’s the chance that you might fail to gain or even lose money. There are a multitude of factors that influence risk in finance, including time horizon, politics, economic changes, and personal actions. When we think about these risks, we typically look at historical economic models and future forecasts to try to understand outcomes. Analytically speaking, there are numerous algorithms available to crunch numbers and quantify risk. Behaviorally speaking, there are various rules and heuristics - like diversification or hedging - that help us mitigate risk. At Mana, we use all of these external tools and approaches, but critically, our analyses start first at the client level. Before we can determine asset allocation strategies, we first must determine individual risk tolerance.
On tolerance...
Risk tolerance describes the degree of variability in investment outcomes that an individual would be okay with. It’s important that all clients get in touch with their own risk tolerance and that we have a clear discussion about it to arrive on the same page before we start working together. Our general philosophy at Mana is that all investments should be assigned to specific goals, and critically, risk tolerance for a client isn't necessarily aligned to risk tolerance for a specific goal. We use holistic conversations to gain a deeper understanding of the importance and meaning of each client’s goals, leaning on teachings from George Kinder's life planning techniques.
The whole idea behind risk is a matter of statistics - typical risk tolerance questionnaires will ask you something like - how much would you feel comfortable losing? But at Mana we know that doesn’t really get to the core of it. Let’s say you don’t want to lose more than 15%, but you also need to make 10% to achieve your goal. Losing 15% may actually be a normal course of business in an investment that makes 10% (defined by standard deviation / volatility) - so if the only thing you declare is not wanting to lose 15%, you might not actually have any shot of achieving your goal. Your earnings goal might be unachievable if you are unwilling to take that risk, and can’t adjust your savings to compensate for it. And then let’s say you have 20 years to achieve your goal, well losing 15% at some point over the course of this investment is somewhat likely - think of it as the cost of doing business - based on your ability to save. This is why the simple question, “how much would you feel comfortable losing?”, is incomplete in its sentiment. There is a functional relationship between risk and return in the market, which is another reason that working with a financial planner to understand the details of your investments is so important.
Some of the trickiest cases of risk understanding for financial advisors are couples, because everyone’s perception is a bit different. Drawing on our general philosophy, when we engage with couples, we steer risk tolerance conversations towards goals. Anchoring our understanding based on mutual goals and plans works way better than analyzing risk at an individual level, which always involves a compromise. We also do a thorough analysis of each couple’s spending habits, income, and savings. Client perception and self reported tolerance is only a part of our equation, as we also calculate and consider how much money clients are reasonably able to save, and whether or not they have a full emergency fund in place already. We can then combine all of these factors (and sometimes more) with shared goal prioritizations to form a representative and useful risk tolerance to operate within. We recently evangelized the advantages of goals-based investing for couples in an article by the Wall Street Journal!
Time horizon is another key consideration in our process of determining risk tolerance. In fact, it’s often our primary determinant for asset allocation selection. The advantage of basing a decision heavily on time horizon is that it is objective and reliable. Longer time horizons help us make safer decisions. For instance, the stock market may drop as much as 40% in a single year, but it has posted positive returns 75% of the time since 1980.
Source: J.P. Morgan
Taking a look at this chart from J.P. Morgan, we can see that in a single year your return vs. risk is pretty dismal, but as you expand out to 10 or 20 years, it starts to look a lot better. This is another case that often requires a savvy advisor, or someone to talk you off the ledge of selling, because peak-to-trough drops within that 20 years can be pretty dramatic and cause emotions to run high for clients.
This is also where historical modeling and economic factors are important, because depending on a client’s time horizon for a specific goal, we will decide to add or remove stocks from their asset allocation. We use Monte Carlo analysis and stress testing of portfolios to gain a deeper understanding of risk in our allocations. We also deep dive into what makes up each asset allocation, paying special attention to diversity and balance. Even with the help of these objective measures, there are often still interpersonal challenges associated with investing as a couple.
What about couples who disagree?
Oftentimes, disagreements happen as a result of wishful thinking or lack of communication. At Mana, we love engaging clients around these challenges and finding solutions that resolve them. As mentioned above, really leaning into goals based investing is typically the answer. Although it’s impossible for any two people to be perfectly aligned on their perception of risk, every couple has a shared vision for the future that can be illustrated and elucidated through concrete goals. Ranking these goals can be another way to map and understand risk so we can execute a plan. For example, if a couple has a mutual dream to retire early while simultaneously funding their children’s private education, there may be some conflict with risk tolerance and overall planning communication. It may be the case that the retirement dream is more of a “nice to have”, whereas private college education is an immediate need. In this case, funds could be allocated to give the highest probability of early returns to support a potentially debt-free college experience, and greater risk could be taken with regards to investing towards early retirement plans (which we now know wouldn’t lead to massive disappointment if those risks didn’t pay off in time). In addition to investment strategies, we often help couples adjust their savings or spending habits to give better certainty of achieving mutually important goals.
In our work, we find that couples often converge in their overall risk tolerance over time. Stephanie’s background is in risk management for hedge funds, and she is passionate about sharing her understanding of cost as risk in investments. We absolutely love educating clients on the technical aspects of finance, as well as holding open conversations in a regular cadence to make sure we’re in touch with long and short term plans. We find that this level of support can really help individuals work as partners not just in life, but also in a financial context. Being a part of each client’s life journey is really important to us, and this connection brings a lot of fulfillment to both sides of the planning experience.
In summary, the world of risk and risk tolerance is a complex space filled with cognitive and analytical challenges. But the alternative to investing is cash, which often has low returns compared to inflation. Simply saving cash can be a terrible decision in the long run, since you will actually be losing monetary value over time. Investing is a much better option for protecting wealth over the course of your life, even if it does come with risk. Financial decision making is tricky, and can cause a lot of heartache in relationships if it isn’t navigated carefully. Working with a financial advisor is a fantastic way to gain a deeper understanding of your own risk tolerance as well as your partner’s. It’s crucial to recognize tolerance as more than a feeling, and rather a weighted combination of practical, objective, and subjective information. At Mana, we help couples anchor these thoughts and feelings to their goals and dreams, always staying focused on clients realizing their best lives. It turns out that engaging deeply with risk can actually help us all feel a bit safer in the long run.
Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.