Risk Objectives

An example of an absolute risk objective would be that the client does not want to lose more than 5% of her capital over a particular period.

Relative risk objectives relate risk to a certain benchmark that represents an appropriate level of risk.

Risk tolerance is a function of BOTH:

• a client's ability to take risk, as well as,
• her willingness to take risk.

Ability to take risk

The ability to take risk is a function of several factors including:

• time horizon,
• expected income, and 
• net worth.

Generally speaking, a client with a longer time horizon, high expected income and greater net worth has a greater ability to bear risk.

Willingness to take risk

A client's willingness to bear risk, on the other hand, is based on more subjective factors including 

• her psychological makeup and 
• level of understanding of financial markets.

4 scenarios:

1.  Ability to take risk - below average.  Willingness to take risk - below average

The investor's overall risk tolerance is below average

2.  Ability to take risk - above average.  Willingness to take risk - above average

The investor's overall risk tolerance is above average

3.  Ability to take risk - below average.  Willingness to take risk - above average

The investor's overall risk tolerance is below average

4.  Ability to take risk - above average.  Willingness to take risk - below average

The investment manager should explain the conflict and implications to the client.

When there is a mismatch between a client's ability and willingness to take risk, the prudent approach is to conclude that the client's tolerance for risk is the lower of the two factors.

Any decisions made must be documented.

Understand Your Risk Capacity and Risk Tolerance

You must stay invested in the securities markets to earn market risk premiums

The securities markets pay risk premiums. You have to have your money invested and at risk to be paid a risk premium.

Attempting to avoid risk or losses by jumping in and out to "time the markets" does not work. Scientific finance studies demonstrate the both amateurs and professionals are lousy at market timing.

Historically, U.S. securities markets have paid substantial risk-adjusted returns or risk premiums to investors. While risk premiums have been substantial, they have occurred irregularly. There have been intervening periods of losses, some of which were substantial. (See: How stable have common stock equity risk premiums been over time?)

To earn market risk premiums, your assets must be invested and exposed to potential risk or loss. The more risk you can tolerate, then the higher your potential return and perhaps the rougher the investment road you may travel. Those who have better emotional tolerance for asset volatility can more easily weather market sell-offs.

Practical considerations will also affect your tolerance of investment risk.

In difficult times, whether you need to liquidate risky assets at depressed prices will depend on your expenses and on your other other holdings of less risky, salable assets. Paying necessary living expenses and taxes are good reasons to withdraw funds. Trying to time the markets for a better return is not a good reason.

If you do not need to take out money during a market retreat and recovery cycle, then risk tolerance is solely emotional. For a risk tolerant investor with stable earned income, the recent bubble crash was just a few years of unpleasantness, if he or she was fully diversified and, therefore, not heavily loaded with technology and communications equities. The same, however, could not be said for those who were poorly diversified and also found themselves to be highly risk averse, when risk actually happened. This is especially true, if job loss forced the liquidation of assets at depressed values.

To some degree, all sane individual investors are averse to risk, so risk tolerance is a relative rather than absolute issue.

Therefore, you need to judge your preference or tolerance for risk relative to other investors. While very few people like investment risk, those who can tolerate it better are those who will be less uncomfortable when risk happens from time to time and market values decline by a little or a lot. Tolerating the potential for loss is the cost that investors occasionally pay so that they are always at the table, when the markets deliver their positive rewards.

The vast bulk of individual investors’ publicly traded investment assets are held in the primary cash, fixed income, and equity financial asset classesin the form of individual securities or funds. Your relative investment risk tolerance should influence how your assets are allocated among these primary financial asset classes. If your actual asset allocation is more risky than your risk tolerance, you may not be able to handle the downturns. You might panic, when you should stand firm. If your asset allocation is less risky than your risk tolerance, then you are likely to need to spend less and save at a higher rate to reach your goals.

Nothing is certain about this process, and that is the nature of investment risk. However, the scientific investment literature is relatively clear on certain points. Amateur and professional investors are just not good at timing changes in the markets. Active strategies that attempt to time market turns have under-performed continuous investment strategies. Consistently and profitably calling serial market turns correctly has been a skill beyond mere mortals and certainly beyond the skill of even the most proud of professional and individual investors.


It is better to buy into the asset markets in proportion to your preferred asset allocation and risk tolerance and to stay in the securities markets through thick and thin.

Trying to sit on the sidelines and jump in when things seem safe simply does not work. When things seem safer, they also seem safer to others. In this situation, securities prices will have already reflected this confidence. Most of the "upside juice" or risk premium will already be reflected in current asset prices and only current securities holders will have been paid. (See: Introduction to investment valuation and securities risk)

The converse of trying to jump out to avoid the downturns also does not work. Real-time securities markets are auctions about the expected value of future securities returns. Particularly toward the downside, markets can react extremely rapidly. Getting out in time does not work, because it is usually too late when you realize you should have sold. Worse, however, you might jump out too early and be absent from the table when the market moves upward. Staying in the markets just tends to work better.

If you are more highly risk averse, it is more appropriate for you to select an asset allocation that reflects your relatively higher risk aversion.

You would hold a relatively small portion of your assets in the more risky equity asset class. Therefore, you might be more comfortable and more able and likely to keep your smaller equity allocation invested at all times. Having a smaller, but sustained exposure to equity assets tends to work much better for the more risk averse investor, compared to jumping in and out of the equity markets in larger proportions.

If you stay out of the markets due to such fears, then you are likely to need to save far more to reach your goals. Over-cautiousness is not a free ride. There is never a safe time to be in the markets, because investing is always inherently risky. There is never a safe time to be out of the markets, because you cannot earn investment risk premiums on the cash under your mattress. (See: VeriPlan helps your to compare investment risk-return tradeoffs)

Finally, you should periodically rebalance you assets back toward your planned asset allocation proportions.

To minimize the negative impacts of investment transactions costs and taxes, you should rebalance infrequently and in a planned manner that anticipates deposit and withdrawal transactions that you would need to do anyway for other reasons.

If you want to understand your personal asset allocation and risk-return tradeoffs over your lifetime, VeriPlan provides powerful, automated "what-if" planning facilities. You can rapidly develop and analyze a range of fully personalized scenarios to see whether your asset allocation strategy would achieve your objectives with a level of risk that is acceptable to you. VeriPlan provides five adjustable and fully automated mechanisms to determine your preferred lifecycle asset allocation. VeriPlan gives you full control over rates of asset returns and asset return variability, and it automatically rebalances your assets annually. It even projects the annual expense coverage by your safer cash and bond assets throughout your lifecycle.

___________________________________________________________________
http://www.theskilledinvestor.com/ss.item.174/you-must-stay-invested-in-the-securities-markets-to-earn-market-risk-premiums.html

A Long Look at Risk: Avoid making the wrong choices at precisely the wrong moments.

A Long Look at Risk 

Most of us aren’t honest with ourselves about how much investment risk we can handle. Even worse, we tend to change our minds at market tops and bottoms, making the wrong choices at precisely the wrong moments.

An accurate assessment of risk is important. But you can view risk in many ways.

RISK CAPACITY:  David B. Jacobs of Pathfinder Financial Services in Kailua, Hawaii, usually starts with risk capacity. Young people have a great deal of risk capacity, since they have their whole career ahead of them to make up for any mistakes. A football player might have much less risk capacity, since he could have only a few years of high earnings. And some retirees have plenty of risk capacity, if they have a solid pension.

RISK NEED:  Then Mr. Jacobs moves to risk need. Need is driven by goals.Someone with no heirs and $20 million in municipal bonds might not care so much about significantly growing the portfolio. But if that person suddenly becomes passionate about a cause, he or she may want to double that amount in a decade to create an endowment or put up a building.

RISK TOLERANCE:  Only then does risk tolerance become a factor. “You have to help people visualize what the risk means,” Mr. Jacobs said. “If a year from now, your $1 million is $700,000, how would it change your life? Does that mean you can’t go visit your grandchildren? I’m trying to dig down and make people think of exactly what their day would be like.”

Your financial advisers: Rules for the New Reality

Rules for the New Reality
by Ron LieberThursday, February 26, 2009
provided by
Back in September, before we were all inured to the tottering nature of so many financial giants, investors were looking for someone to blame.

More from NYT.com: • How About a Stimulus for Financial Advice? • Coaches for a Game of Money• Readers Weigh in With Tips on Jobs and Money

So when Prince & Associates, a market research firm in Redding, Conn., polled people with more than $1 million in investable assets, it wasn’t any great surprise that 81 percent intended to take money out of the hands of their financial advisers. Nearly half planned to tell peers to avoid them, while 86 percent were going to recommend steering clear of their firms.

In January, Prince took another poll of people with similar assets, and only a percentage in the teens had engaged in trash-talking. Just under half of the investors had taken money away from their advisers.

All of the bad feelings, however, raised a simple question that’s even more essential when we’ve all been so severely tested. What, exactly, does your wealth manager owe you? And what can you never reasonably expect?

Some of the answers are basic. Your financial advisers should have impeccable credentials. They should be free of black marks on their regulatory or disciplinary records. They should agree, on Day 1, to act solely in your best interest, not theirs or those of any company that might toss them a commission.

More from Yahoo! Finance: • Why Index Funds Are Still Winners• 5 New Investing Rules for Retirement• The $38 Billion Shadow Stimulus
Visit the Retirement Center

But other standards are less obvious, and the carnage in the markets provides an excellent opportunity to review them.

What You Should Expect

A Long Look at Risk

Most of us aren’t honest with ourselves about how much investment risk we can handle. Even worse, we tend to change our minds at market tops and bottoms, making the wrong choices at precisely the wrong moments.

An accurate assessment of risk is important. But you can view risk in many ways.

David B. Jacobs of Pathfinder Financial Services in Kailua, Hawaii, usually starts with risk capacity. Young people have a great deal of risk capacity, since they have their whole career ahead of them to make up for any mistakes. A football player might have much less risk capacity, since he could have only a few years of high earnings. And some retirees have plenty of risk capacity, if they have a solid pension.

Then Mr. Jacobs moves to risk need. Need is driven by goals. Someone with no heirs and $20 million in municipal bonds might not care so much about significantly growing the portfolio. But if that person suddenly becomes passionate about a cause, he or she may want to double that amount in a decade to create an endowment or put up a building.

Only then does risk tolerance become a factor. “You have to help people visualize what the risk means,” Mr. Jacobs said. “If a year from now, your $1 million is $700,000, how would it change your life? Does that mean you can’t go visit your grandchildren? I’m trying to dig down and make people think of exactly what their day would be like.”

A Balance Sheet Audit

Diversifying the risks in your portfolio is merely the beginning of the process. Burt Hutchinson, of Fischer & Hutchinson Wealth Advisors in Bear, Del., trained as an accountant before earning his certified financial planner designation. He believes in tax diversification too, across a range of savings vehicles with different tax rules.

He wants his firm to act as a sort of personal chief financial officer, looking at liabilities as well as assets and at spending as much as saving. “How are you tracking your cash flow?” he will ask. “Is it increasing? Decreasing? Do you have any idea where it’s going?” He says that a good financial planner should ask to see your tax return, not just your investment portfolio.

Customization

A 100-page financial plan lands with a thud and comes with fancy leather binding. What you might not know, however, is that off-the-shelf software probably produced most of it.

More from NYT.com: • How About a Stimulus for Financial Advice? • Coaches for a Game of Money• Readers Weigh in With Tips on Jobs and Money

Not that there’s anything wrong with computer projections. But most people’s financial lives, even those of the wealthy, do not contain 100 pages of complications. And enormous financial plans can be overwhelming and difficult to follow.

“Plans need not be over 10 to 15 pages,” said Timothy J. Maurer of the Financial Consulate in Hunt Valley, Md. “But every bit of it should be customized.”

To eat the same dog food

When Dr. Marc Reichel, an anesthesiologist from Beaufort, S.C., grew tired of stockbrokers pitching investments they would never use themselves, he queried a new adviser about her own portfolio. “Unlike with my previous experiences, she said, ‘Sure, this is what I have, take a look,’ ” he said. “And it wasn’t just a one-time thing. It was ongoing.”

Dr. Reichel has been with that planner, Sheila M. Chesney, of Chesney & Company in Sheldon, S.C., for nearly a decade. “The only way I could feel like I did a good job was to say that I’m doing the same thing,” she said. “If it wasn’t working for me, I wouldn’t be doing it.”
Boredom

You have the right to be bored by your financial life. There is no shame in putting things on autopilot, saving the same percentage of your income in a diverse collection of index funds for decades on end.

This philosophy drew skepticism in the 1990s for Spencer D. Sherman, when his clients wondered why he wasn’t putting them in individual technology stocks. But Mr. Sherman, a financial planner and the author of “The Cure for Money Madness,” thinks his clients would be better off seeking thrills far away from the financial markets.

More from Yahoo! Finance: • Why Index Funds Are Still Winners• 5 New Investing Rules for Retirement• The $38 Billion Shadow Stimulus
Visit the Retirement Center

“If you’re in a diversified passive portfolio, you have nothing to talk about at a cocktail party,” he said. “But why don’t people make investments a smaller part of their lives? It almost seems like people need to fulfill that desire for excitement somehow, and investing is an easy way to do it.”

What You Should Not Expect

Market Timing

It would’ve been nice if every wealth manager had moved clients to 100 percent cash positions around the middle of last year. The truly prescient might have put some money down on exchange traded funds that bet on the decline of various stock indexes.

But those who did probably didn’t call the top in 2000, or get back into the market in early 2003. Nor will they know when the current bear market will end. For the same reasons that most mutual fund managers consistently underperform market indexes over the long haul, especially after taxes and fees, your adviser is not clairvoyant, either.

“In the 1990s, a lot of people wanted to know how much we were going to beat the market by and our strategy for market timing,” said Laura H. Mattia, wealth management principal with Baron Financial Group in Fair Lawn, N.J. Most people know better now, after riding the roller coaster for a decade or watching the unraveling in recent months.

Low Risk, High Return

After market timing, Ms. Mattia said, this fiction is the second of two great false beliefs in money management. “It’s the same as wanting to believe in a magic pill that will cause you to lose 20 pounds,” she said. “People are looking for the easy way of achieving their goals, but things just aren’t always necessarily so easy.”

The notion seemed abstract until December. Then, after years of smooth supposed returns, prosecutors accused the wizard Bernard L. Madoff of making it all up. Recently, the Texas financier Robert Allen Stanford came under scrutiny for peddling high-yielding C.D.’s that may have been too good to be true. Anyone who utters the phrase “low risk, high return” deserves close examination.

To Be a Pest

Remember that you hire advisers in order to set some clear, long-term goals — which probably shouldn’t change every day in reaction to the ups and downs of the markets.

“One of my biggest roles is to take the emotion out and be a calming force,” said Lon Jefferies of Net Worth Advisory Group in Midvale, Utah. “If clients want to continually change their risk tolerance when the market drops another 300 points, that’s going to make it impossible for the relationship to succeed, because they’re changing the rules almost every day.”

Rather than calling every day to second-guess yourself and your adviser, set aside dates to sit down and examine your feelings.

Certainty

This one may be the toughest to swallow. Jay Hutchins, of Comprehensive Planning Associates in Lebanon, N.H., never promises an outcome. The past year, he said, should make it easier for new clients to understand why.

Even a collection of Treasury bills and top-rated, immediate fixed annuities is not enough to establish certainty in his mind. “When you decide you’re going to build a house, you build the building accordingly and with prudence, depending on whether tornadoes or earthquakes are most likely to threaten it,” he said. “Then, an airplane flies into it. Did you do anything wrong to fail to plan for an airplane crash? Of course not. You plan for what is going to be most likely.”

While Mr. Hutchins is not yet ready to predict a return to the 1930s, he doesn’t believe it makes sense to place the likelihood of it happening at zero either.

Life, in general, is unpredictable.

And for the adviser, that uncertainty should be cause for some modesty.

Milo M. Benningfield, of Benningfield Financial Advisors in San Francisco, notes that we tend to value aggressiveness. “But when I think about the meltdown, I feel like it was overconfidence,” he said. “It was a colossal lack of modesty that led people to underestimate the risk involved and believe that they understood things more than they did.”

So to him, a big part of being modest is recognizing your own limits. “You’re more inclined to say, What if I’m wrong?” he said, adding that he often reaches out for help on insurance and estate planning matters. “I think the definition of incompetence is failing to recognize that you don’t know something.”

http://finance.yahoo.com/retirement/article/106652/Rules-for-the-New-Reality;_ylt=AgyVt.WIeqvSeWfCieaON9tO7sMF