Back in 1984, when billionaire and former presidential candidate Ross Perot sold the company he founded—Electronic Data Systems—to General Motors for $2.55 billion, he invested the entire nest egg in a portfolio of muni bonds. He reportedly explained that he liked the low risk and the tax-free income, and he figured the 4% coupon ($102 million per year, for you quants) was high enough: “How much money do you need?”
I think about that quote every time I hear the mention of “risk tolerance.” I know, determining a client’s risk tolerance is considered an important step in designing their investment portfolio; and that it’s even required of brokers as part of FINRA’s CYA documentation to justify the products that were sold, oops, I mean recommended, should the client relationship turn sour. But talking about a client’s risk tolerance always seemed to be asking the wrong question. It’s like a surgeon asking you how much pain you’re going to be comfortable with in your upcoming operation. Or a car salesman who starts his spiel with: “Well, there are a lot of safety features you could have in your car—seat belts, air bags, padded dashboard, brakes, etc.—but they can be pricey, so it all depends on how much risk you and your family want to take on the road.”
To my mind, there’s only one rational question when it comes to investment risk: How much risk does the client need to take to meet their financial obligations and reach their financial goals? Taking more risk than that isn’t a matter of preference or taste, it’s just dumb. Worse, it’s dangerous—because it increases the risk that that client won’t be able to afford to do some things that they need and/or want to do.
Years ago I ran into the one of the smartest financial planners I’ve ever met, who not coincidentally had the best solution to handing client risk that I’ve heard of, before or since. In her firm, Matrix Financial Advisors in Santa Monica, Calif., Roberta Smith would ask her clients to prioritize their financial needs and wants, starting with the specific obligations that the client feels he or she needs to meet (college educations, life insurance, health insurance, etc.), then the things they should fund (retirement income, a trust fund for grandchildren, etc) and finally the things that would be nice to have (vacation home, boat, golf club membership, horses, etc.).
The important thing is that these are listed in order of the client’s priority, not the advisor’s. Once Roberta did that, then she would quantify the amount needed for each goal, and only then think about how each goal would be funded: by matching the risk to priority.