What does a financial advisor really do? I was asked this question recently by a high school student I was mentoring who was interested in going into this field. I of course answered it in an academic, complicated way in which I talked about planning and investments and understanding markets. As I thought more about that question this week though, I realized the answer was much simpler, and the things I mentioned were just tools in the advisor tool belt. Financial advising is just helping people not to make poor financial decisions and guiding them to good financial decisions. There are several good financial decisions out there to make, but avoiding the irrational, poor decisions is probably more important than always picking the winners. Now I learn something new every day in this business and I do not know it all by any means, but in working with clients so far in my career, I have identified four steps that help people avoid financial missteps: understanding personal risk tolerance, having a diversified portfolio, avoiding the temptation of market timing, and developing a financial plan.

● Understanding your personal risk tolerance. Risk tolerance is a word massively overused and misunderstood in the financial world. It is also often exclusively tied to two things: age and investments. Webster’s definition for risk is “to expose to hazard or danger” and the definition of tolerance is “capacity to endure pain or hardship”. So essentially a person’s risk tolerance is how much they are willing to expose themselves to pain. That pretty much says it, but my scientific definition for risk tolerance is “a person’s ability to sleep soundly”. This cannot be quantified into just your age. I have met with clients in their 30s who could not sleep at night if they were 100% invested in stocks. Likewise, we have clients in their 80s that never want to own a bond and are perfectly comfortable with massive swings in their investments. It applies to more than just your asset allocation as well, we recommend 3-6 months of an emergency fund, but we have some clients that sleep better knowing they have $100,000 to $1,000,000 in cash if they need it. Mathematically it makes no sense to pay off a 3% mortgage, but many people do it, and we recommend it to many people. The point is, understanding your personal risk tolerance is crucial to long-term success because people make emotional decisions when they lay in bed at night thinking about the mortgage payment or a $20,000 drop in their aggressive investment accounts. This is one of the reasons why we do financial plans before we ever invest a dollar of capital for new clients. Helping a client determine risk tolerance is just as important for our client-advisor relationship as it is for their financial success.

● Diversifying your portfolio. Diversification can sometimes be the most frustrating part of any portfolio. Over the last 5 years, with hindsight, it makes zero sense to have a diversified portfolio outside of simply buying the S&P 500 or just Apple stock. However, that game plan only works until it does not. This year AAPL is down 8%, the S&P 500 is down over 6% and an asset like Gold is up 8%. Markets go up and markets go down but a diversified portfolio that utilizes index funds and ETFs gives investors exposure to make sure that when some things are going down others will likely be going up.
Along with diversifying the portfolio it is important to revisit step one and make sure to rebalance your diversified portfolio. If you have been invested in large cap equities over the last two years, that allocation could have grown to make up 50% of your portfolio. You may need to sell down some of this exposure back to your original 35% and buy into areas that have not performed as well. This allows you to maintain a portfolio that stays within your overall risk tolerance of say 70% stocks and 30% bonds while also diversifying your equity exposure into areas that have not run as much.

● Avoid Timing the Market. In a webinar that Quint and I did recently, a question was asked “why when Joule talked about potential turbulence in the markets, did we not just go to cash?”. The question is perfectly valid, but the answer is relatively simple as well. You truly cannot be sure what markets will do. If there is one thing I have learned for certain, it is that nothing is certain in the markets. Folks that made the decision to pull their money out of the market in March 2020 were certain that markets would not recover, at least not anytime soon. When Putin invaded Ukraine on February 24th, many people were certain we were going to World War 3 and the world was ending. Yet here we sit 6 weeks later with the market up almost 5% and a war still going on. This graph looks at what your return would be each decade if you missed either the 10 worst or 10 best days of that decade. Although missing a bad day is great, you then must get back into the markets at the correct time in order to gain the upside as well. This graph shows the importance of time in the market versus trying to correctly predict every decline.

How do you combat the uncertain nature of markets then without timing the market? For those that have gone through our financial planning process, you know that in your retirement analysis we determine your probability of success. All that means is the percent chance that you do not run out of money before you die. That percent chance is determined by a Monte Carlo simulation or a simulation that runs thousands of possibilities to determine your percentage. Why do we do this type of plan analysis? Because it limits our need to be certain or to always be 100% right about the markets. The graph below shows one of these simulations.

The shaded regions represent those thousands of possible outcomes, from Russian invasions to higher gas prices, to Covid declines, to legitimate bear markets. All these scenarios are factored in, which allows for our clients with high probabilities of success to be more comfortable even in uncertain times.

● Developing a Financial Plan. I think for many people, financial planning can feel like going to the dentist office for a checkup. You know you should, but you are pretty sure it is going to be painful, and you would rather not know any news than get bad news from your dentist. Although planning can be daunting, I think it is much less about good or bad news and more about determining your financial and life goals and making sure you can meet those goals. So, whether it is our team or any other advisor, planning should help a client understand their risk tolerance and make sure their investment allocation is in line with their goals. Planning should help clients understand the importance of diversification, whether that is strictly with market investments or other investments like real estate. Planning should also help individuals feel comfortable with their investments so that in times of “pain” there is not the temptation to panic, change investment strategy, or time the market. All in all, planning helps individuals back up decision making with math, which allows them to avoid the emotional, poor decisions and search for potentially successful opportunities.

There are probably several more ways to avoid making poor financial decisions, but from my experience, these four have helped our clients reach their long-term goals and objectives while avoiding the potholes. If you are interested in learning more about risk, Quint did a great educational video on risk in the markets, which can be found here. Also, I want to invite anyone who has a financial problem weighing on their sleep or would like to learn more about developing a big picture plan or if you just would like a second opinion, feel free to sign up for an introductory meeting with our team here. We would love to learn more about your financial journey.