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Financial Planners, Volatility, and Asset Allocation

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.

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  1. I couldn’t agree with you more. I work for a firm that deals heavily with investments, and when it hit the fan starting last year, our planners lost very few customers. This was because they are all taught – TO TEACH – their clients that the markets go both up and down.

  2. Some investors insist on zero volatility. How can you believe it’s ‘wrong’? It clearly leads to less than ‘the best’ results in the vast majority of, but not all, situations.

    It’s wrong for you and me, but that’s not the same thing as its being wrong for anyone else..

  3. Mark, I’m not saying it’s the wrong decision.

    I’m simply saying that before we assume it’s the right decision, we’d better make sure that the investor truly knows what the consequences are most likely to be.

  4. It’s fine if someone wants to dodge volatility, but it should be the job of an advisor/planner to point out what this means.
    “You’ll have to die earlier / Save more / etc.”

    In return they are all trade-off’s… do whatever makes sense for you.

    Is the extra stress associated w/ volatility exceed not drinking coffee everyday? (hey that sounds like it’d be doubly health lolol)

  5. Mike-

    This is a great conversation. Thanks for taking it on. While I agree that it is the job a good planner to educate clients on the impacts of the trade-offs. One thing to be very careful of is this statement:

    “…increased knowledge about the cyclical nature of markets and the actual (as opposed to purely psychological) consequences of volatility leads to increased volatility tolerance.”

    Investment “risk” and how you FEEL it is an emotional problem. Education/knowledge might help, but for most people you will not solve emotional problems with logic. You can throw all the fact & figures you want at this and people will still FEEL scared when they open their statement and see a 20% loss. When you are scared, you want out. It is part of being human. We want to run from what causes us pain, and get more of what is giving us safety/happiness.

    So it is important to be educated. But it is also very, very, important to understand that you will FEEL scared and develop strategies to deal with it without making the BIG mistake.

    Make sense?

  6. Hi Carl.

    Thanks for taking the time to reply.

    For what it’s worth, I’d agree that there’s no chance whatsoever of entirely eliminating the emotions that go into investing. However, I really do think that we can train our minds to respond with one emotion as opposed to another. Or, at least, we can train our minds to mitigate some of the emotions that arise due to certain events.

    For example, how many financial planners do you know that feel scared when their portfolios decline by 20%?

  7. agreed. BUT, in 15 years of advising clients and studying behavioral finance I actually think we underestimate the role that emotion plays for most people.

    There are people that are hardwired in such a way that fear and greed are not an issue, but for most of us IT IS GENETIC.

  8. It is what kept our ancestors from being eaten by sabertooths a long time ago.

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