Risk Tolerance Tied to Market Performance

The state of the economy can impact the risk tolerance of a portfolio recommended by an adviser, a paper finds. 

A study comparing investors’ risk tolerance with the Consumer Sentiment Index (CSI)—a measure of the consumer outlook on the U.S. economy, including employment and inflation predictions—found that risk tolerance and the CSI are positively correlated. In other words, as the outlook on the economy improves, investors are more risk tolerant, and as the economic outlook appears grim, risk tolerance decreases, according to “Do Large Swings in Equity Values Change Risk Tolerance?”

The research also found that advisers who create portfolios based on risk tolerance assessments tend to keep their recommendations more conservative during a recession than in an economic expansion—meaning plan participants may end up with depressed results following a market decline. “If you recommend a conservative portfolio when equities are cheap, you risk exacerbating these long-run individual investors’ underperformance that we see from bad market timing,” explains Michael Finke, a professor of personal financial planning at Texas Tech University and co-author of the study.

Finke suggests that advisers might want to use some kind of handicap for portfolio creation to offset this effect. “You edge up a little bit during a recession and edge down during an expansion,” he says. Advisers also should be sure to reassess risk tolerance every few years to make sure portfolio recommendations remain in line with the client’s goals.

Finke says the research makes some important points about how plan participants make investing decisions. “The most harmful thing investors do is sell low,” he says.

In mutual fund performance, this is known as the dumb money effect, Finke says. “Investors tend to pile into the sectors that have gone up the most, and pull out from those sectors when values fallen,” he tells PLANADVISER. Stock mutual funds in the first three months of 2009 showed record net outflows of $20 billion each month, according to Finke. “It’s about the worst thing they could have done,” he says. Investors who left their money in equities instead of pulling out at the wrong time eventually recaptured two-and-a-half times their original value, he says.

Cognitive Decline and Risk Avoidance

Age also plays an important part in investment decisions, Finke says. “The older you are, the more likely you were to pull money out during the 2009 recession,” he says. The reason is not nearing or being in retirement, but cognitive decline.

In cases where cognitive decline is measurable, Finke says, people are more likely to avoid risk, and to pull out of stocks. In 2009, he says, cognitive decline accounted for some investors pulling out of the equities market. Once a person begins to make poor decisions, it is reasonable not to take on as much risk, but the decision to sell in 2009 turned out to be a very poor one, he says.

This information can be useful for advisers to pass on to sponsors for use in participant education. “Providing some sort of guidance in bear markets might help employees maintain a focus on their long-run objectives,” Finke says.

Finke feels that most employees can turn to target-date funds (TDFs) as a way to avoid this particular loss. “The best thing that’s happened in the defined contribution world is the movement toward TDFs as a default investment,” he says. “Because they are self-rebalancing products they will prevent much of this investor loss.”

TDF use has certainly skyrocketed, Finke observes, pointing to data that shows about $50 billion invested in TDFs in 2007, and more than $500 billion in TDFs last year.

“My perspective is that they help reduce some of the losses from these biases,” Finke says. Investors can still make changes to their accounts, but they are less inclined to when they have their money in a product that automatically rebalances.

The study also found:

  • Average monthly risk tolerance scores increased as price/earnings ratios increased, and decreased as dividend yields increased. Respondents became less risk tolerant as equity valuations became more attractive.
  • Average risk tolerance scores demonstrated little monthly variation, despite large swings in equity values during this time period. This suggests that individual risk tolerance scores are determined more by individual preference than external market forces.

“Do Large Swings in Equity Values Change Risk Tolerance?” is available in the June issue of the “Journal of Financial Planning.”