PPs are generally averse to taking on additional risk in their portfolio, which makes accounting for SLR a somewhat easier task.
In last month's article we reviewed the mechanics of a very important subject: standard of living risk, or SLR. SLR will be discussed in the next few articles. Often advisors will recommend an investment program to a client based purely on their risk tolerance questionnaire. One element that is rarely captured in a risk tolerance questionnaire (or anywhere else for that matter) is how risky a person's lifestyle is in relation to her investment portfolio. To advise clients properly, financial advisors should assess the financial responsibilities of their clients and determine if clients have ample assets to cover these responsibilities.
In the next four articles, we are going to use the concept of SLR in a practical way by analyzing how standard of living risk information can help us in working with each behavioral investor type (BIT). The first BIT we will examine is the passive preserver (or PP). Our process will be to review the basics of each BIT, present a scenario involving an SLR with each BIT, and then review an example of how one might create an investment program for each BIT, with and without an SLR.
Review of Passive Preservers (PPs)
As you may recall, PPs place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Some PPs obsess over short-term performance and are slow to make investment decisions because they aren't entirely comfortable with change, which is consistent with the way they have approached their lives--being careful not to take excessive risks. Many PPs are focused on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and homebuying. Because the focus is on family and security, PP biases tend to be emotional rather than cognitive. As age and wealth levels increase, this BIT becomes more common. Behavioral biases of PPs tend to be security-oriented biases such as endowment bias, loss aversion, status quo, and regret. PPs also often exhibit cognitive biases such as anchoring and mental accounting.
Suppose you are beginning an advisory engagement with a new client, Mary. You give her a standard of living risk questionnaire after having given her a standard risk tolerance quiz and a test for behavioral biases of conservative investors. Based on the answers to bias and risk tolerance questionnaires, you have classified her as a PP. The answers to the SLR questions have identified her as someone with a standard of living risk. This means that she may not have an extra cushion of money available to her to withstand a shock to the system such as a job loss, disability, or other adversity based on her current lifestyle. Generally, this implies that she should accept less risk in her portfolio than those clients without a standard of living risk. Because she is a passive preserver, she is not predisposed to taking on additional risk in her portfolio anyway (which makes working with PP clients with an SLR an easier task than with some other BITs with SLRs). In creating Mary's recommended allocation, you decide to use another PP client, Sue, as a baseline. Sue, however, does not have an SLR.
Your task is to recommend an allocation that meets Mary's retirement goal while managing the volatility needed to reach that goal. After running the numbers, you have determined that a 4%-5% return should be sufficient for Mary to reach her retirement goals. Sue's return need is nearly identical to Mary's. Which allocation should you recommend to Mary? The following analysis presents two investment programs, one for Mary (with an SLR) and one for Sue (without an SLR).
Allocation for a Passive Preserver BIT with and without an SLR
As we know, PP clients:
For Mary, a PP with an SLR, you decide that she may have difficulty sticking with a portfolio allocation with a probability of a loss year at greater than 10%. For Sue, a PP client without an SLR, that number is 15% or less. The following are Mary's and Sue's allocation recommendations along with some statistics.
Commentary: Although Mary's allocation was relatively conservative and only delivered a 4% return, it was a good alternative given that Mary is a passive preserver with an SLR. Sue has the ability to accept more risk than Mary given that she does not have an SLR. In the end, both allocations were in the recommended range to meet their goals--which was 4% to 5%--but Mary's allocation was a more conservative at 4% than Sue's, which was slightly more aggressive at 5%. Naturally, this is only an example, and facts will certainly change when real people are involved. This example illustrates how to change an investment program recommendation for two similar clients, one with an SLR and one without one.
Next month we will learn how to use SLR information with Friendly Follower BITs.
Get practice-building tips and information from our team of experts delivered to your e-mail inbox every Thursday. Sign up for our free Practice Builder e-newsletter.