The last quarter of 2014 saw an increase in global stock market volatility. This unease has carried on into 2015, with many experts predicting it will continue throughout the rest of this year.
After five years of rising prices, this is a firm reminder markets are never predictable in the short term. The problem for advisers is that many clients dislike volatility and focus on the short-term outlook, rather than being patient and allowing their portfolio the time to do its job and meet their long-term goals.
Being prepared, therefore, for how clients might react to swings in markets is crucial. Investors ideally will determine an asset allocation and investment plan taking into account their risk tolerance and, by managing their emotions, stick to it despite market movements.
If markets boom, investors can view this as an opportunity to take profits and, when markets correct, buy into the correction consistent with their long-term asset allocation.
Advisers must manage their clients’ investment expectations and understanding of volatility so they will not be surprised by the misery of the markets when they correct. The starting point is assessing a client’s risk tolerance with a valid and reliable risk tolerance test.
However, this assessment is fraught with pit holes. Traditional non-psychometric risk assessments typically fail to accurately measure risk tolerance, which is a significant indicator of how an individual might react to their portfolio’s behaviour in different market conditions.
Many tests include questions relating to other matters such as an investor’s perception of risk and their risk capacity. These tests invariably give inaccurate readings of risk tolerance.
Moreover, many traditional risk assessments can cause clients to consider themselves “growth” investors in the good times and “conservative” in the bad. In reality, it is an investor’s perception of risk that changes through market cycles, which can, in turn, drive a change in an investor’s behaviour.
For example, last year, when global markets surged, investors bought shares with elevated P/E ratios. Prices were going up a lot faster than corporate earnings and the risks were getting bigger, yet people still bought the shares, seemingly blind to the possible consequences.
In contrast, in recent months, global uncertainty has led to investors selling equities, driven by fear, because they have perceived them to be high risk. The investor’s tolerance for risk has not changed, just their perception of how much risk they are taking, which has resulted in a change in their behaviour.
An investor’s risk tolerance is, in contrast, largely stable over time.
The scientific discipline of psychometrics has developed to make personal traits such as risk tolerance measureable. A test can be completed in as little as 10 minutes and is an essential input into a person’s risk profile.
A robust risk tolerance questionnaire is, in psychometric terms, one that is valid and reliable. Valid means the questionnaire measures what it purports to (that is, risk tolerance alone) and reliable means it does so consistently with known accuracy.
Our own data from more than 750,000 risk tolerance tests completed over 15 years supports the view risk tolerance is fairly stable over time. It might decrease slightly with age and may also change as a result of major life events but it is not subject to market conditions.
Various studies of investors over the years have shown that reacting to market movements is a major destroyer of personal wealth. Many investors tend to repeat the same mistakes of selling towards the bottom of the market cycle and buying towards the top. They lack a meaningful framework from which they can make judgments about their portfolio’s likely behaviour in the context of their risk tolerance.
What this all means is that to help clients’ focus on long-term performance, advisers need to educate them about investment risks and returns and, crucially, manage their expectations. Equally, advisers must assess clients’ risk tolerance properly before making any investment recommendations so no one faces any nasty surprises when equity markets correct.
Volatility may well be an enduring feature of stock markets in 2015 but with the right risk assessment supported by education and information clients should be able to weather the storm.
Paul Resnik is co-founder of FinaMetrica