William R. Nelson Ph.D. finds that the popular risk tolerance tools often provide poor recommendations that might cost advisors clients
To remain in business, financial advisors need to:
- Know how much risk their clients can tolerate
- Recommend risk appropriate portfolios to their clients
- Set client expectations regarding account volatility and returns relative to the popular equity indexes.
Without performing these three functions, financial advisors (maybe you) risk losing clients and being shut down for fiduciary violations.
Real Risk Meter is the intuitive, user friendly, fast, easy to explain solution.
FREQUENTLY ASKED QUESTIONS
Why Is Real Risk The Right Risk?
The primary purpose of risk tolerance measurement is to provide investors risk appropriate portfolios that help facilitate perseverance during stock market declines. Real Risk is in my experience how investors feel stock market declines and is thus the right way to measure investors’ risk tolerances and investments’ Risk Ratings.
Real Risk is the amount that a portfolio will likely fall at some time in the future, from peak to trough. The Risk Meter allows investors to experiment with different levels of risk and return in order to feel the tradeoffs and decide how much real risk should be taken.
How Do Real Risk, Real Risk Tolerance, Risk Meter, and Risk Rating Relate to Each Other?
- Real Risk is the concept of percentage fall from peak to trough.
- Real Risk Tolerance is the amount of Real Risk that an investor decides they want to take.
- The Risk Meter is a tool used by investors and advisors to experiment with and discuss the tradeoff between risk and return to help determine an investors Real Risk Tolerance.
- Risk Rating is the amount of Real Risk an investment may experience.
How Does the Risk Meter Determine the Expected Return for a Portfolio’s Real Risk?
The return of a 100% stock portfolio is the common assumption of 10% per year.
A zero risk investment has an assumed return of 2.5% which is reasonable for the last 20 years. The returns for Real Risk between 0 and 50% are the weighted averages of 10% and 2.5%
How Does the Risk Meter Calculate the Risk Ratings of a Portfolio of Investments?
The Risk Rating of a portfolio of investments equals the sum of the percentage Real Risks contributed by each of the investments in the portfolio. To calculate the Risk Rating of a portfolio, we must know the Risk Rating of the investments in the portfolio.
These values are based on the Real Risk of each during the prior 40 years.
- The Real Risk associated with a diversified equity portfolio at 50%.
- The Real Risk associated with a diversified fixed income portfolio is 10%.
- The Real Risk of fixed annuities is 0% because of their contractual guarantees.
The Real Risk Rating of a portfolio is calculated as the sum of the Real Risk of the holdings within the portfolio.
- Stock Risk + Bond Risk = Risk Rating
- (Stock%*Real Risk Rating of Stocks)+(Bond%*Real Risk Rating of Bonds)=Risk Rating
- For example, assuming 20% equity and 80% fixed income, the equation equals…
- (20%*50%)+(80%*10%)=Risk Rating
- 10%+8%=18%=Risk Rating
Why is RealRiskMeter So Simple?
Simple is easy to understand, easy to explain, and easy to believe in.
Flaws in a simple system are more easily identified. Flaws in the complex risk tolerance systems remained hidden, sometimes for decades.
A complex system may be more likely to lull users into misplaced confidence regarding the accuracy of their output. Because each stock market decline is different, using historical data to make precise predictions is foolish. RealRiskMeter humbly strives to provide prudent advice, not predict the future.
Simple is beautiful.