Risk tolerance is supposed to vary according to the age, needs and goals of investors. But a topsy-turvy market is all it takes to show that risk tolerance is no less volatile than their emotions.

When markets go to the moon, many of your clients are willing to take on as much risk as possible. But when markets fall off a cliff, “risk” quickly becomes a four-letter word.

Ted Rechtshaffen, president of TriDelta Financial Partners Inc. , a Toronto-based financial planning firm, says this behaviour presents a significant challenge because risk tolerance is one of the few things in investment management that is really important.

He says the first thing people at his firm try to assess with clients isn’t their risk tolerance but how much risk they need to take to achieve their goals. “It’s something that most people in the investment industry,” he says, “are not able to help a client answer.”

Rechtshaffen recommends starting off by getting a clear picture of your client’s household income and his or her expenses, build in taxes and pension income, and project it all out 10, 20, 30 or 40 years. Then, assuming a 5% growth rate, determine whether the client will have enough money to cover his or her spending requirements in retirement. If the answer is “yes,” do the same analysis with 4% and 3% growth rates.

“If you still have enough money to do what you want to do at 3% returns, it doesn’t mean you go for 3%; but you understand the rate of return you need to achieve,” he says. “If you understand that, it makes it easier to say, ‘Should I buy Apple shares because they’ve gone up 120% in the past year?’”

Rechtshaffen says many people will say to him they want to earn a 10% return in their portfolio; when he asks why, they usually look at him like he’s nuts. “Look at what that really means,” he says. “Will it help you meet your goals? There is no free lunch. If you want a 10% return, the odds of having a really bad year increase. You want to make sure the investor is saying, ‘If I lose 20%, am I OK with that?’ If the answer is no, you can’t go for 10%. They’re two sides of the same coin.”

A recent survey by Scotia Capital Inc. found that Canadian households recently set a record for risk aversion: they are currently sitting on more than $1 trillion in cash. The report points out that there have been two periods of significant increase in Canadians’ preference for cash — one after the dot-com bubble burst and 9/11, and the second after mid-2007.

According to the report: “There are multiple drivers, but we think the dominant one is excessive complacency and risk aversion on behalf of households when managing their finances. Large cash holdings at a particular point in time may make sense if one is bearish, but sustained over many years is difficult to justify.”

Rudy Luukko, investment funds editor at Morningstar Canada, a Toronto-based research house, says investors have shown a strong preference of late for lower-risk products such as balanced funds or portfolio funds. That puts those investors in a difficult position, however, because if they’re not prepared to accept the short-term risk of losing their capital, they’ll be “sure losers” because they are likely to fall well short of achieving their financial goals, Luukko says: “Investors who shun the equities markets are, in the long term, probably relegating their portfolios to very low returns in comparison to what they would probably be able to earn by taking on additional risk.”

John McCallum, a finance professor at the I.H. Asper School of Business at the University of Manitoba, compares investors to boxers who have had a pretty good run and won a few fights but never taken a real shot: “Then you go in and get knocked cold. Are you more risk-averse? Then you go for a few more bouts and nothing bad happens, and eventually you get back to your old self. Any sensitive person would be cautious after the market went down 50%.”

Even governments can over-compensate for bad news. McCal-lum says he’s concerned that governments will overreact in their haste to be seen to be doing something — anything — about fixing financial regulation. “There is a huge tendency in humans, and certainly in government, to overreact on both the upside and downside,” he cautions. “The pendulum will swing too far and they will regulate too much, and also regulate in ways that have unintended consequences that aren’t very good. The way you regulate the capital markets affects the amount of capital that goes into the markets, and that affects the amount of plants, machinery and equipment that make you productive.”

@page_break@McCallum says that after the econ-omy began heading into recession at the end of last year, governments in both Canada and the U.S. announced gigantic infrastructure programs and cut interest rates to essentially zero. Almost a year later, a “massive wall” of spending is being injected into the economy, just when it’s turning around and starting to grow on its own. “The ideal thing would have been to let monetary policy work. It takes time,” he says. “Now, we’re spending gazillions on infrastructure in North America, and the third and fourth quarters are going to be good. The pendulum [swings] too far.”

Rechtshaffen says that part of a good financial advisor’s job is to try to remove the behavioural aspect from a client’s investment decisions. There’s a natural tendency to want to buy a mutual fund that posted a 30% return last year, much more than a fund that lost 10%, he says: “People chase performance.”

Indeed, what’s perpetually difficult with risk, Rechtshaffen says, is to get your clients to do what seems counterintuitive at the time. If he was meeting with a client last February and was asked for his advice, he invariably recommended putting more money in the markets. Nine out of 10 clients said there was no way in the world they would do that.

But they told him they appreciated his comments, nonetheless. He says people were “thrilled” to have their money in cash, earning 0%, because they thought the sky was falling everywhere else.

“At that moment, their risk tolerance was really low. And, as a result, they missed out on some good opportunities,” he says. “When markets are strong, it’s hard to say, ‘We should be buying bonds that are earning 4%.’ On the flip side, when Time magazine has a story about investing in the stock market and becoming rich, you know it’s probably time to sell out. That’s when everybody thinks there’s no risk in the stock market and everything will only go up.”

So, how do you alter behaviour that’s been wired into our DNA for thousands of years? Rechtshaffen says the way to get beyond the unpleasant feelings that come with doing the opposite of what you want to do is through experience, either your own or by working with an advisor who has been through a couple of market cycles.

He says that over the past 50 years, the worst rolling 12-month period was from June 1983 to June 1984, during which time the market was down by 45%. The best rolling 12-month period over the same half-century? Why, the following 12 months, of course, when markets were up by 86%.

“When the markets really get killed is usually when they rebound the most,” he says. “That’s part of the experience side of things.” IE