INVESTOR RISK PROFILING

Risk is a big focus in the investment industry. But I don’t think the industry does a good job communicating the really important risk factors for investors.

In addition to the standard disclaimers that investment professionals need to communicate (past performance is no guarantee of future results, etc.), the typical approach of the investment industry is to create a risk profile for each investor. They run everyone through a series of questions to measure an individual’s risk tolerance.

This is basically a measure of how well an individual investor can deal with the “buy and hold” strategy. They want to know if a person might panic in a stock market collapse. This part of the process is a good thing. It’s important to know if some investors can handle investing in the stock market or not. Some people cannot stomach even small short-term losses to their accounts, and they would not be good candidates for stock investments.

Someone with a very high risk-tolerance (not afraid of short-term losses) would be set up with a more aggressive investment strategy consisting of mainly stock market investments. Someone with an average risk tolerance score would be set up with a less aggressive strategy such as a blend of stocks and bonds.

It all sounds very scientific and professional. But this process creates a perception of exactness and control that is extremely misleading.

First, the process leads one to believe that investment professionals can control the results and truly minimize risk-- that they can somehow dial in the perfect asset mix for an individual, so that they achieve a specific investment return tied to a specific level of volatility and risk. But that simply isn’t possible.

Secondly, risk profiling depends upon asset allocation being an effective strategy.  Since asset allocation doesn’t work, building risk profiling on top of it is just silly.

The investment industry is providing an illusion of safety—not a real solution.

Too much time is spent by advisors on risk tolerance and fear—and not enough time is spent linking different kinds of risk with the expected returns of particular investments. Some investments do carry a lower risk of short-term loss, but they also come with much lower investment returns. And the risk of short-term loss is very different than the risk of long-term or permanent loss. That distinction should be made very clearly.

Most of all, the risk of not choosing investments that consistently perform well over the long term is the biggest risk of all—the risk of missed opportunity—and the investment industry gives precious little attention to that risk.

Let’s talk about the different kinds of risks that investors really need to understand and consider when making investment choices. There are three kinds of risk that I would like to explore with you.

1. The first risk to consider is the risk of short-term losses from a particular investment.

2. The second risk to consider is the risk of long-term or permanent losses from a particular investment.

3. And the last risk, is the risk of generating low investment returns in the long term, which leads to insufficient retirement accounts when people reach the age of 65.

The investment industry usually lumps short-term loss risk and long-term loss risk together in discussions with clients. They’re two different things, and this needs to be understood by all investors.

Most investments other than cash or guaranteed income funds carry the risk of short-term losses, because all financial markets are volatile. The stock market can and does go up and down on a fairly regular basis. That risk is pretty well understood by most investors.

In 2022 and 2023, investors learned that bonds can and do lose value in the short-term. Financial professionals who do risk profiling will often move investors into bonds if their risk tolerance is low. Those investors were probably not expecting to suffer through short-term losses in their bonds of roughly 20% in 2022 and 2023.

There is a big difference, however, between short-term volatility—which produces short-term losses—and bad investments that lose money in the long term.

Long-term losses or permanent losses happen when someone invests in an individual stock and that company goes out of business or loses significant portions of revenue to a competitor. Long-term losses can also happen when someone invests in a stock fund that represents a particular developing country, and that country goes through political upheaval. Long-term losses can occur when a commodity like oil is replaced by another form of energy. 401(k) and IRA investors should avoid any investment that carries a high risk of long-term loss. Permanent long-term losses can destroy your retirement plans.

The last risk factor—the risk of low long-term investment returns— is the risk that’s not talked about enough. Bonds do provide a little less short-term loss risk than stocks. But that lower risk of short-term loss comes at a cost: investors are dramatically increasing the risk that they will not create an investment account with enough money to retire comfortably and securely. And investors need to know that lower short-term risk does not equal no risk. Bonds lost a lot of money in 2022 and in 2008.

If you look at long-term investment returns, there’s a huge difference in performance between bonds and the best stock investments. The best stock investments can produce average returns of 9% to 10% per year. Bonds, on the other hand, can only be expected to produce average returns of 4% to 5% per year—about half of the gains from stocks. This difference in performance means that a stock investor will end up with millions of dollars more in retirement than a bond investor.

Don’t lose sight of your long-term goals by paying too much attention to some useless risk profiling score. 

Stay Disciplined My Friends,

Phil

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Disclaimers The Beyond Buy & Hold newsletter is published and provided for informational and entertainment purposes only. We are not advising, and will not advise you personally, concerning the nature, potential, value, or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. Beyond Buy & Hold recommends you consult a licensed or registered professional before making any investment decision.

Investing in the financial products discussed in the Newsletter involves risk. Trading in such securities can result in immediate and substantial losses of the capital invested. Past performance is not necessarily indicative of future results. Actual results will vary widely given a variety of factors such as experience, skill, risk mitigation practices, and market dynamics.