Tuesday, May 11, 2010

5.11.2010 More on risk and volatility

Crossing Wall St has a further meditation on the Volatility = Risk implication of Felix's most recent statement.

On further contemplation, I want to clarify my previous statements.

I worked with mid to high net worth individuals for most of my professional life before school, creating financial plans to provide for retirement, college education, and other goals. Determining the appropriate exposure to stocks is probably the most important thing that we did as advisers. Some clients are younger, less risk averse, or have higher income; some clients are older, more risk averse, and have less income flexibility. These metrics, amongst others, are the critical things to evaluate the risk tolerance, and thus the proper allocation of stocks.

Maybe this is a moment of delayed Upton Sinclair*, but risk tolerance shouldn't change because the market is volatile, and so an individuals portfolio shouldn't change because the volatility of the market has quickly changed (as it is wont to do). An individual's risk tolerance is in relation to the volatility of the market in general, not the volatility of the market on a daily basis. If an adviser has done his or her job right, they understand their client's psychology and will be conservative with their estimation of a client's risk tolerance when the market is bullish, and aggressive with their estimation of a client's risk tolerance when the market is bearish. Indeed, this is what we attempted to accomplish with our practice in 2006 to 2007, where the standard analysis suggested a 80/20% stock/bond portfolio, we moved clients to 65/35 stock/bond portfolios.

The implication of Felix's advice is that daily volatility is a reason to shift the allocation of a portfolio. If you've done your job right, the volatility that a client is exposed to is the volatility that they can stand. This means in low volatility time periods, they want to take more risk; in high volatility time periods, they run for the exits. A client should be unhappy with you in bull markets, but happy in bear markets.

Your investment allocation strategy shouldn't magnify the behavioral irrationalities of a retail investor.

* "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"

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