Risk Tolerance in a Volatile Market. A Spectrem Group White Paper

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2 An investor s description of his or her own risk tolerance is not a reliable indicator of a willingness to make specific investment choices. In fact, this white paper will show that there is limited correlation between how an investor describes oneself and how he or she actually makes investment decisions, or how his or her portfolio is actually constructed. The desire to preserve capital is one of the primary factors distinguishing how an investor s true risk tolerance can be defined. Conservative investors generally have a shorter investment horizon and therefore are less open to volatility. Along with age, investment time horizon is linked to risk tolerance. The two factors, however, are not dependent upon one another with many younger households also having a short time horizon. By far the largest percentage of investors describe themselves as Moderate when describing their risk tolerance. An equal number describe themselves as either Conservative or Aggressive. Risk Tolerance 57% 2% 20% 20% Most aggressive Aggressive Moderate Conservative One might assume that wealthier households have a higher risk tolerance, however, this is not the case. Surprisingly, more Millionaires (those with more than $1 million of net worth) consider themselves Conservative than non-millionaires, and a larger percentage of non-millionaires consider themselves Aggressive than Millionaires. 61% 5 2% 3% 18% 22% 26% 1 Most aggressive Aggressive Moderate Conservative Millionaires Non-Millionaires 2016 Spectrem Group *Investors with $100K - $25 MM net worth, not including primary residence 2

3 Age impacts risk tolerance with those 44 and under and those 45 to 54 more likely to describe themselves as Aggressive or Most Aggressive. Similarly, those 55 to 64 and 65 and older are more likely to consider themselves to be Conservative or Moderate. Gender plays more of a factor in risk tolerance with women being more likely to define their risk tolerance as conservative or moderate than men. Male Female 44 and under and older Most aggressive 2% 2% 5% 2% 1% Aggressive 2 13% 3 28% 18% 13% Moderate 57% 58% 45% 52% 60% 61% Conservative 16% 28% 10% 15% 21% 25% The belief that risk tolerance transcends investment decisions is reflective of other decisions made by an individual. When asked whether they would prefer a job with fewer financial awards but more job security or a job with more financial rewards but less security, it is not surprising that Conservative investors chose the stable job and Aggressive investors chose the financially rewarding job. Rate Your Preference Between Job Security vs. Financial Rewards By Investor Aggressiveness Moderate Aggressive/Very Aggressive Conservative 100 More job security-less financial rewards Total Less job security- More financial rewards By Age Age Age More job security-less financial rewards Age 44 and under Age 65 and over Less job security- More financial rewards 3

4 Regardless of how they define themselves, investors are more likely to consider the potential losses when making an investment decision rather than the potential gains. Not surprisingly, Conservative investors are the most likely to consider the losses while Aggressive investors will consider the potential gains. Moderate investors lean more towards considering losses rather than the potential gains. Concerns When Faced With Major Financial Decision 12% 5% 26% 4 31% 48% 50% 55% 3 40% 20% 5% Always the possible losses Usually the possible losses Usually the possible gains Always the possible gains Total Aggressive or Very Aggressive Moderate Conservative In order to gain an understanding of factors that define risk tolerance, the key attitudes regarding risk were isolated and factors were compared against how an individual defined their risk tolerance. For example, it can be presumed that My primary goal is to grow assets rather than protect principal is important in determining if a person is Conservative or Aggressive. Therefore, it is consistent that those who are Aggressive in their investment behavior are more likely to have a primary goal to grow assets rather than protect principal. Thoughts on Risk Tolerance and Asset Allocation - By Investor Aggressiveness Level of Agreement With Following Statements (0=Disagree, 100=Agree) My primary goal is to significantly grow assets rather than preserve assets I am unwilling to invest in anything that will result in a loss of principal My primary goal is to grow assets rather than protect principal I primarily seek to protect principal but I am will to take some risk Conservative Moderate Aggressive or Very Aggressive Total

5 One s willingness to invest in fixed income can easily be correlated with risk tolerance. Conservative investors are more willing to invest in fixed income. Likewise, willingness to invest in growth stocks can identify if a person is Conservative or Aggressive. Aggressive investors are more likely to invest in growth stocks. The willingness to invest in fixed income or growth stocks are more important in identifying an investor s risk tolerance than are bonds and dividend paying stocks. An Aggressive investor is more likely to invest internationally, and this variable is also one of the more prominent variables for predicting if a person is Conservative or Aggressive. Thoughts on Risk Tolerance and Asset Allocation - By Investor Aggressiveness Level of Agreement With Following Statements (0=Disagree, 100=Agree) I invest in growth stocks I invest primarily in large cap dividend-paying stock I invest as recommended by my investment advisor I invest internationally I invest primarily in fixed income I invest primarily in bonds I invest only as my financial advisor tells me to I invest in non-market correlated investments such as gold, futures, commodities and other I invest primarily in insurance products Total Aggressive or Very Aggressive Moderate Conservative 5

6 Another factor influencing risk tolerance is an individual s investment time horizon. Conservative investors generally have a shorter time horizon for their investments. In contrast, Aggressive investors have a longer time horizon. Investment Time Horizon - By Investor Aggressiveness Total 13% 26% 31% 31% Aggressive or Very Aggressive 10% 18% 31% 41% Moderate 2 36% 31% Conservative 26% 3 15% 21% 1-3 years: these investments need to remain very liquid 3-5 years: I can only tolerate a small amount of volatility 5-10 years: I can tolerate a moderate amount of volatility Over 10 years: these assets are invested for the long-term and can tolerate short-term fluctuations in value 6

7 When investors are asked about their primary investment goal, most investors indicate it is to create a blend between capital preservation and growth. This goal is reflected by an average of 58 percent of investors. In contrast, only 17 percent are focused on capital preservation. Primary Investment Goal 20% 5%Total Aggressive or Very Aggressive Moderate Conservative 7% 3% 17% 12% 12% 16% 1 42% 58% 35% 46% 70% 40% Emphasis on capital preservation Create a blend between capital preservation and growth Emphasis on growth with only moderate concern about fluctuations in value Emphasis on growth with little concern for fluctuations in value Participants in a focus group and in some individual interviews were asked to define the percentages of their portfolios and the amounts held in various types of investments. The individuals defined their own levels of risk tolerance. The Self-Declared Aggressive Investor 40% 25% 30% 25% 15% 5% 0% Marcy Fixed Income Hedge Funds Real Estate REITs Individual Stocks Futures Mutual Funds 7

8 The Self-Declared Moderate Investor 40% 35% 15% 5% 0% 0% 5% Ron Fixed Income Hedge Funds Real Estate REITs Individual Stocks Futures Mutual Funds The Self-Declared Conservative Investor 35% 20% 25% 30% 30% 0% 0% Andrea Fixed Income Hedge Funds Real Estate REITs Individual Stocks Futures Mutual Funds 8

9 Looking at the goals of individuals in conjunction with how they define themselves is more revealing. Investors who define themselves as Aggressive indicate that almost half of their emphasis is on a blend between growth and preservation. Only 12 percent is Growth only. Seventy percent of Moderate investors believe there should be a blend of growth and preservation. Conservative investors are more interested in preservation at 42 percent. Conservative 51% 38% 2% Transfer my investment to another investment manager Moderate 25% 62% 3% Move my investment to a more conservative portfolio Aggressive or Very Aggressive 8% 17% 68% 7% Maintain my present disciplines, longterm strategy Total 28% 58% Develop a more aggressive strategy to recover my losses While half of investors generally indicate they would not change their portfolios based upon a single year s loss, Conservative UHNW and Mass Affluent investors are more likely to consider a change within a twelve-month period. Conservative investors, regardless of wealth level, are more likely to change an investment offering after a 5 percent loss than others. A 10 percent loss will cause Moderate and Aggressive investors to reconsider an investment. When asked about the actions an investor would take if their portfolio lost value over a two-to-three year period, Conservative investors were much more likely than others to move into more conservative investments. Interestingly, across all risk segments, roughly 10 percent blame the investment manager and would transfer to a different investment manager. 9

10 Investors who might inherit money are most likely to place those assets into a mutual fund regardless of wealth level and how much they might inherit. Conservative investors are more likely than others to put an inheritance into a savings account or money market account. There are some differences based upon the amount of the inheritance. Aggressive investors are overall more likely to invest in stocks than Moderate or Conservative investors. Where Would You Invest Money From an Inheritance? 43% 51% 55% 58% 33% Mass Affluent How Would You Invest a $100,000 inheritance? 22% 17% 10% 16% 26% 16% 8% 11% 8% 15% A savings account or money market mutual fund A mutual fund that owns stocks and bonds A portfolio of 15 common stocks Commodities like gold, silver and oil 33% 55% 60% 52% 41% 26% 40% Millionaire How Would You Invest a $500,000 inheritance? 23% 12% 10% 1 13% 7% 7% A savings account or money market mutual fund A mutual fund that owns stocks and bonds A portfolio of 15 common stocks Commodities like gold, silver and oil 40% 47% 3 57% 55% 36% 33% 25% 25% UHNW How Would You Invest a $1,000,000 inheritance? 13% 10% 7% 0% 3% 10% A savings account or money market mutual fund A mutual fund that owns stocks and bonds A portfolio of 15 common stocks Commodities like gold, silver and oil Total Aggressive or Very Aggressive Moderate Conservative 10

11 The most obvious conclusion from the data reviewed herein is that investors cannot define their risk tolerance in the manner commonly used by the industry. Each definition of Conservative, Moderate or Aggressive is different. It is important for advisory firms and financial advisors to understand and apply this information. So, if an advisor cannot simply ask an investor about risk tolerance, how does he or she determine how to most effectively assist the individual? Basically, success can be achieved through the same methodology that hundreds of successful advisors have used throughout the years. Advisors need to develop a personalized relationship with their existing and potential clients that allows circumvention of the use of traditional words describing risk tolerance. By developing a personal relationship with the client, an advisor can understand the needs, time horizon and overall personal philosophy of the individual. What should an advisor consider? Do not presume to know an investor s time horizon. It is easy to presume that an investor is planning to save until retirement and then begin to withdraw from his or her portfolio. This is not necessarily true. The client may need access to funds sooner due to a wedding or to pay for a college education. They may want to purchase a vacation residence or help out an ailing family member. While investors become more conservative the closer they get to a time horizon, the time horizon is not necessarily retirement. Determine whether an investor sees the glass as half empty or half full. Clearly an individual s personality has an impact on his or her risk tolerance. If an individual is generally optimistic, he or she is more likely to be more comfortable with aggressive investments. Quiz your client on how he or she views a situation outside of the context of an investment. This will give you a better understanding of how he or she might assess an investment risk. Growth versus capital preservation is key in identifying an investor s risk tolerance. It is interesting to note that having a blend is important to all investors, especially those who define themselves as Moderate. The key to understanding your client is being able to define where that subtle change to preservation overcomes growth interests. Investors who define themselves as conservative are less positive about the near future. Advisors should not try to convince these investors that the economy is recovering or force them into investments that they are not ready to accept. Even aggressive investors own fixed-income investments. Whether it is due to a desire to be properly diversified or part of the investor tension between seeking return but preserving capital, even the most aggressive investors generally own some fixed income investments. 11

12 Aggressive investors are more open to international investments. One of the biggest differentiators between individuals that defined themselves as Aggressive compared to those who felt they were Conservative was their interest in international investments. Make sure you introduce your Aggressive investors to international opportunities. Understanding the difference between how investors think compared to how they behave is critical to forming a successful relationship with clients. Advisory firms need to focus on understanding the issues motivating the behaviors of their clients and the related time horizon. More importantly, an advisor must understand the personality of each investor and how he or she makes decisions. METHODOLOGY: The research from this white paper is derived from Spectrem s quantitative and qualitative research with investors. This report was fielded online with 1,865 investors. Of these, 893 had a net worth of $1 million or more (137 were Ultra High Net Worth UHNW investors, with $5 million or more in net worth and 756 were Millionaire investors, with $1 million - $5 million in net worth, not including their primary residence). There were also 972 investors with a net worth of less than $1 million, not including their primary residence (Mass Affluent investors), included in this research. In addition to the quantitative research described above, qualitative research was conducted with investors with over $1,000,000 of net worth. Half of the investors interviewed had more than $5,000,000 in net worth. You might also be interested in Client Loyalty Among Affluent Investors Financial service providers are continuing to fight the never-ending challenge of converting prospects to clients and clients to loyal clients. What makes a client loyal to their provider? Is it the level of personal service they receive, or are they more concerned with investment returns? All of this and more is explored, along with a significant amount of demographic analysis. Available Now. Why Investors Switch Advisors The report includes data from over 500 investors who have switched financial advisors within the past five years. Investors must have at least $100,000 in net worth, not including primary residence. This report includes both quantitative analysis from multiple wealth segments as well as focus group results with investors not currently using a financial advisor. Available Now. High Net Worth Insights Newsletter Spectrem s publication is the comprehensive pipeline to the ultra affluent. High Net Worth Insights provides insights into the needs and expectations of affluent and ultra-high net worth households, enabling financial advisors to strengthen their client relationships and position their services to attract new business. Available now in monthly publications. Other Available White Papers Would They Stay or Would They Go? (Advisor vs. Firm Loyalty) Socially Responsible Investing Social Security: When and Why And many more. 12