When I was a kid one of my favorite questions was "What do you want to be when you grow up?". It allowed me to dream, based upon what I wanted at that time. At first, I thought I wanted to be an NFL quarterback for the Houston Oilers or the Dallas Cowboys. But by the time I was 10 or 11, after comparing my speed and my arm strength to some of the top athletes on the local lot where we played, I realized some other profession might be a better choice for me. In my teens, I thought I wanted to be an electrical engineer. Then two semesters of Thermodynamics in college caused me to reevaluate that idea. It has often been said that the most useful plans are those that can survive reality.
Not all financial advisors are fiduciaries, but if they truly are, they will ask you a series of specific questions to help determine your risk tolerance before advising you. You've seen these questions before. They ask you things like “If your investment lost this much, what would you do?” and “How many years before you need this money?”. Normally the greater the return potential of any investment, the greater that investment will fluctuate in price before possibly reaching its potential. This is basic risk and reward. One of the goals of the advisor is to try and get you to envision various scenarios when the price may move down a significant amount, and to picture how you would react at that time.
The problem arises when everyone tries to overlay their situation and future circumstances with the same 5-10 questions. While there are always exceptions, in 8-10 years from now you will probably feel different about some things. Unforeseen events, however subtle, can change our plans. Things that were never considered a risk before now need to be given more thought, based on new information. While we can never predict the future, we can more personalize the risk tolerance questions. Instead of asking "Can I handle a 20% drop?", ask yourself "Can I handle a 20% drop at the same time my company decides to downsize?". Another good question may be "What if the drop occurs at the same time I had planned a large purchase?". Often there are other people involved in your risk profile whose circumstances may or may not be able to withstand the same % drop you feel you can. Who else is dependent on you to support their plans and goals? We need to always plan for ourselves AND for the world we live in.
We are all optimists. We are confident that we can adjust and handle almost anything that comes our way. But we cannot handle 100% of the occurrences, 100% of the times they happen, especially if we have not given them any consideration beforehand. The best title of this article maybe should be “The biggest fib we tell ourselves when talking with our advisors”. We confidently tell ourselves we can handle a price pullback within a certain percent. In many respects that confidence is what helped us earn a large nest egg in the first place. But the risk questions we are asked need to be given a lot of thought - and not only at the beginning of your relationship with the advisor. Think deeper. Be honest with yourself and think through multiple scenarios.
Not only will your advisor thank you, but you will be thanking yourself when the next prolonged bear market correction arrives.