Carl at Behavior Gap posted an article yesterday about the different variables involved in a financial plan. He made an excellent point: Rather than have a greater equity allocation than you’re comfortable with, you can adjust some of the other variables. You can save more, retire later, spend less in retirement, or leave less to your kids.
This is absolutely true, and I think we’d do well to discuss these other variables more frequently. (And if you’ve been around here for long, you know that I’m not a big fan of the typical stop-working-completely concept of retirement.)
Carl also said something that I want to focus on more precisely:
“Financial planning is NOT about trying to talk yourself into putting all your money into stocks and then dealing with the pain in down markets. It is about deciding which levers [i.e., other variables] to pull and when.”
As it stands, I agree with this statement.
I would like to add, however, that–in my opinion–an absolutely essential function of a financial planner is to help investors (specifically those with a long way to go until retirement) understand that:
- Volatility and down markets do not, in fact, have to be painful, and
- Reacting to down markets as if they’re painful will cause nothing but problems.
For example…
Imagine this scenario: A 30-year-old investor comes into a financial planner’s office for a meeting. During the meeting, the investor explains that he’s uncomfortable with almost any volatility, so at the moment his entire 401(k) and IRA are invested in fixed income investments.
Now, it seems to me that it’s the planner’s responsibility at this point to make it explicitly clear what a 100% fixed income allocation is likely to mean in terms of retirement possibilities.
In my experience, most investors tend to dramatically underestimate the amount of savings necessary for the retirements they’re envisioning. Similarly, I worry that many investors don’t fully understand what a low equity allocation will mean for them in terms of retirement options.
There’s no need to tell the investor that this is the wrong decision, but it’s important to at least make sure it’s an informed decision.
Teaching volatility tolerance
I’m absolutely convinced that increased knowledge about the cyclical nature of markets and the actual (as opposed to purely psychological) consequences of volatility leads to increased volatility tolerance.
Note: I’m not saying that it leads to any particular, extremely high level of volatility tolerance, just that I believe it increases it.
There’s no question that a greater tolerance for volatility is a good thing. It can allow an investor to:
- (safely) invest a greater portion of his portfolio in equities, or
- have a greater degree of comfort–and therefore a smaller chance of making a mistake–with whatever level of equity allocation he already has.
And I think that helping an investor develop his tolerance for volatility is one of the most valuable services a financial planner can provide.