Does your client’s risk tolerance still matter?
It is natural to let certain investing rules slide when markets keep ripping. The euphoria of an ever increasing balance can make things like diversification, risk tolerance, and volatility control feel optional or even out of date. Rising rates can make them feel real again.
Interest rates are the ultimate influencer. They sway the value of future cash flows, cost of capital, credit conditions, and the margin for error investors receive when they pay elevated prices for growth. They shape the return investors expect from bonds and the price they are willing to pay for stocks. Interest rates help set the boundaries for what works when.
Not every rate move requires a portfolio overhaul. As we saw, gas prices have had more effect on the current markets than the recent quarter point move. However, an upward trend can have more impact, and investors who have become comfortable with concentrations that only worked under a very specific interest-rate backdrop may be disappointed in a regime change.
3 key points
- Higher rates expose fragility. Small-cap companies, highly levered businesses, long-duration growth stocks, and lower-quality credit may all face a more difficult financing environment when rates rise. Look for quality.
- Bond allocations need scrutiny, too. Fixed income remains important for income, diversification, and capital preservation. Yet broad, static bond exposure can carry more rate sensitivity than a client realizes. Look for agility.
- Behavior is often the biggest risk. A client who thought a portfolio was diversified may react poorly when several holdings decline for the same underlying reason. That is when an allocation problem can become a decision-making problem. Look for a hedge.
Understanding what parts of the portfolio relies on a stable-rate environment and where it has room to adapt is essential.
How to Apply This in 3 Steps
- Map rate sensitivity. Identify holdings whose outcomes depend heavily on lower borrowing costs, multiple expansion, or long-duration cash flows.
- Review fixed-income assumptions. Assess whether a client’s bond allocation is designed solely for income and whether it also has a clear plan for changing rate and credit conditions.
- Prepare the client conversation. Remind people that growth is not the only objective, seeking stability when conditions change is also key. The goal is not to avoid all volatility. It is to reduce the chance that one market force drives the entire client experience.
Risk-managed equity and tactical income approaches may be useful building blocks for advisors who want a rules-based process for reducing exposure during unfavorable conditions while maintaining a long-term investment framework.
Interest rates remain a powerful force in portfolio returns and investor behavior. Advisors do not need to predict the magnitude and timing of the next move in yields, but they should understand how much of a client’s portfolio depends on rates staying benign.
Your Homework:
Review one client portfolio this week for hidden rate sensitivity, then use that review to guide a clearer conversation about diversification and downside risk.
Bio
Eben Burr is president of Toews Asset Management. He serves as a lecturer and coach of applied behavioral finance for Toews’ Behavioral Investing Institute. He assists in training advisors to implement managed risk strategies and build an educational process for managing investor behavior. He lives in NYC with his wife, son, and lots of guitars. Connect with Eben on LinkedIn
Disclosure:
Toews Asset Management is an SEC registered investment adviser with its principal place of business in the State of New Jersey.
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