What is Your Risk Tolerance? | November 2001 Expert to Expert

E2E: What is Your Risk Tolerance?

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Asking clients this question can place them in jeopardy.

By Robert Castiglione

"What is your risk tolerance?" is a question that consumers are often asked at the beginning of a financial planning and advising session. In the financial services industry, it is often thought that high risk means high reward and low risk means low reward. But this isn't necessarily true. In fact, asking clients for their risk tolerance can actually place them in jeopardy.

Here's the key issue: It isn't necessary for consumers to assume high risk in search of high rewards. It should be the goal of every financial professional to provide high reward with low risk as the nucleus of a client's financial plan.

The risk and reward pyramid

The high risk/high reward concept is often illustrated by use of a risk and reward pyramid. Some products at the base of the pyramid are savings accounts, money markets, life insurance cash values and CDs, all of which have low risk and supposedly offer low rewards. At the next level of the pyramid are corporate bonds, municipal bonds, treasury securities and annuities. These products have slightly more risk and therefore supposedly offer greater rewards.

Moving up the pyramid to the next level, we reach stocks, mutual funds and hedge funds, which offer higher risk but the possibility for greater reward. At the apex of the pyramid are riskier products, such as commodities and penny stocks, which have even higher risks but offer a chance for even greater reward.

This pyramid perspective can be problematic because it leads the client to believe that the path to high rewards is through the purchase of higher-risk products. Often, consumers are persuaded by this pyramid approach to take unnecessary risks to achieve their financial dreams or goals.

The financial services industry has attempted to reduce the risks associated with high risk/high reward investing through a variety of devices, all of which have not solved the inherent problem. But time and time again, the investing public fails to meet its full financial potential because each of these strategies has its own limitations.

These strategies include:

Diversification. By its nature, diversification is a defensive strategy that actually increases the chances that your client will own a losing investment. This can create a low risk/low reward scenario.

Leveraging/arbitrage. Both of these strategies can carry high risk, based upon the unpredictability of market conditions.

Dollar-cost averaging. A study conducted by professors from Wright University demonstrated that from 1926 through 1995, investors would have received higher annual returns with lump-sum investing than with dollar-cost averaging.

Market timing /hedging. It is widely agreed among financial services professionals that "Buy low/sell high" is extremely difficult to achieve. This is because there is not enough data to predict the outcome of any market.

Modern portfolio theory. This strategy is based on the notion that one can measure market risk and expected returns and find a balance that is acceptable to the investor. It has yet to be proven that this theory will benefit consumers in the short or long run since past performance is not a measure of future performance.

As long as the selection of investment products is based on the high-risk/high-reward scenario, consumers will not be well served.

High reward with low risk

It isn't necessary for consumers to assume high risk in search of high rewards.

Purchasing the best financial product may not make consumers successful.

This brings us back to the key question: Is it possible for the consumer to achieve high reward with low risk? The answer is an emphatic "YES" and this can be realized with a solution that focuses more on process than on products. Many consumers would be satisfied with a 10 percent to 12 percent rate of return over time without risk.

A key to this solution is helping agents and financial professionals educate their clients about the fact that high risk is not necessary for high reward. When explaining this approach versus the high reward/risk tolerance approach to clients, we often use an analogy. Tiger Woods is perhaps the best golfer of all time, and his achievements to date are remarkable. But what makes Woods a great golfer? Did he purchase the best set of golf clubs in the marketplace today? Is it the golf ball he uses? The answer, of course, is no. If this were the case, anyone could be a great golfer. The answer lies in Tiger's swing. Tiger Woods has a perfected swing.

Consumers can learn from this lesson and realize that searching for, or even purchasing the best financial product may not make them successful.

They must first learn how their money "swings." The strategic planning process can equip you with the tools you need to demonstrate the efficiencies and effectiveness of each money decision, with the purpose of achieving personal financial success with high reward.

Utilizing the macroeconomic concepts in this process, you will be able to demonstrate to clients the benefits of the "proper money swing." Through the use of this strategy, you can coordinate and integrate guaranteed and insured products to achieve long-term rates of return of 10 percent to 12 percent.

This can provide consumers with assured paths of reaching their needs and goals without running the risk of losing their principal. It is the answer consumers have been looking for to create wealth and financial success. It inverts the traditional pyramid, making the guaranteed and insured products the most powerful products, with the greatest propensity for high reward and performance.

Strategic coaches

Give consumers the choice of high risk/high reward or low risk/high reward and they will almost always take the latter. Financial professionals should view their roles as strategic coaches on the money process rather than as planners of product selection. Agents and financial professionals need to take a good look at the methodologies they use in planning their clients' financial future. Placing clients into high-risk investments for such important needs and goals as funding college education or retirement income planning is inappropriate in most cases.

The question What is your risk tolerance?" may have been born from a lack of information about the importance of process in achieving high reward without risk. Can you imagine a NASA scientist asking the astronauts sitting on top of the rocket before launch, "What is your risk tolerance? Which do you prefer? We can get you to the moon more quickly if we take more risk, or we can get you there safely without the risk."

NASA scientists plan their flights with as many built-in guarantees and redundancies as possible. And so, too, every American consumer deserves and has the right to have his lifetime financial journey built around a high-reward and low-risk approach investment.

Financial professionals can use the same philosophy as NASA does on every shuttle flight: "Let's get them there without fail."

Robert Castiglione is CEO and founder of LEAP SYSTEMS, Inc. For more information call 732 424-2888, or email info@leapsystems.com.

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