What is your risk tolerance?

Consumers are often asked “What is your risk tolerance?” early on in a financial planning, financial advising meeting. In some circles of the the financial services industry, it is often assumed that low risk means low reward and high risk means high reward. However this isn’t necessarily true. As a matter of fact, asking financial planning clients for their risk tolerance early on can actually place them in potential financial trouble. The most important thing to learn here is this: you should not assume it is necessary to expose your client to high risk in the hopes of gaining profit; instead you should look to build a low risk core of investments that yield high rewards. The risk vs reward pyramid The risk and reward pyramid is typically used to demonstrate the high risk/high reward theory. Some of the products at the base of the pyramid are CDs, life insurance cash values, money markets and savings accounts, which all offer low risk and supposedly offer low rewards. At the next level of the pyramid are municipal bonds, corporate bonds, annuities and treasury securities. These products have slightly more risk and supposedly offer higher rewards. As we move up the pyramid we reach stocks, mutual funds and hedge funds. These offer higher risk but the possibility for greater reward for your client. At the peak of the pyramid are riskier products, such as penny stocks and commodities. Investing in these items has the highest risk as well as the highest potential for reward. The problem with this model is that it tends to make clients believe that the only way to achieve greater rewards to is invest in high risk areas, leading to unnecessary risks and potential losses. 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 financial planning and investing strategies include:

• Diversification - reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents.
• Leveraging/arbitrage -  the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost.
• Dollar-cost averaging - an investment strategy, that may be used with any currency. It takes the form of investing equal monetary amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
• Market timing /hedging -  the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. This is an investment strategy based on the outlook for an aggregate market, rather than for a particular financial asset.
• Modern portfolio theory -  is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. 

 As long as clients select their investments based off of the high risk/high reward theory, they will not be fully served by their financial planner. How do we achieve high reward with low risk? Now we come back to our key question: Is it possible for the client to attain high reward with low risk? The answer is an absolute “YES”. This can be realized with a solution that focuses more on the process that generates growth instead of the products that attempt to do the same. Many consumers would be satisfied with a 10 percent to 12 percent rate of return over time without risk. Consumers must learn that just because they search for or purchase the best financial product, they may not be as successful as they would like.  It is just like golf; you can go out and buy the most expensive golf clubs, shoes, balls and anything else you can imagine, but those things cannot make you a great golfer Instead, you just master the fundamentals of the sport, and most importantly, the swing. Just like in golf, consumers must learn the “swing” of their money. The strategic planning process can equip you with the tools needed to demonstrate the efficiencies and effectiveness of each money decision, with the purpose of achieving personal financial success with high reward. Again, like in golf, most consumers cannot simply pick up a set of clubs and become great.  Instead, they need some type of instructions, whether it is through lessons, watching a video or playing a round with a friend.  The same applies for learning the “swing” of their money, they need a teacher or coach.  This is where Matheny Advisory Group comes in.  We are your swing coach, your fundamentals coach and your advisor for everything in your financial life.  By working with the above mentioned strategies and partnering with Matheny Advisory group, consumers can begin to learn that they do not have to have a high risk investment in order to achieve a high reward.  They can safely invest their money and still receive the returns they are hoping for.