Digital assets are investments, but the law and regulatory structure around them lacks clarity. As an asset class, the regulatory structure isn’t uniform. This makes the risk of digital assets higher than others. The lack of clarity and risk can be a fertile ground to discuss risk tolerance.
When it comes to financial literacy, student loan forgiveness and mortgage rates may be top of mind for younger plan participants. These may be areas that participants have identified as weaknesses or gaps in their knowledge, but there’s an argument to be made for focusing on the basics of financial literacy. This may be especially true if volatility creates risk for your plan participants. Ask any risk manager what they spend the majority of their time worried about and they’ll answer you simply: the unknown unknowns. Project management depends upon careful planning for risks and surprises. In that way, retirement planning isn’t really that different that project management. This is especially true when it comes to the unexpected. “Surprises can quickly derail a project… This is why taking time to identify risks is an important step in managing projects. There are four categories to risks – known knowns, known unknowns, unknown knowns and unknown unknowns.” Your plan participants may know that they don’t know about the impact student loan forgiveness have on tax planning. They may not know that they don’t know about asset classes in general. Plan Sponsors may want to address both in any educational planning.
One method to address both new topics (like digital assets) and old ones (like risk tolerance) is to simply combine the two. Recent studies show that the majority of investors are contemplating adding digital assets to their retirement portfolios even though they view them as risky. “61% of respondents view digital assets as a strong retirement investment option, even though 57% view them as volatile investments. [45%] labeled digital assets as risky investments.” This conflict may be a learning opportunity to discuss risk tolerance, asset classes and diversification.
Understanding what a digital asset is can help frame the basics about asset classes. “A digital asset is a digital representation of value made possible by advances in cryptography and distributed ledger technology, also known as a blockchain. The cryptography of a digital asset is unique to that asset and can be tracked using the distributed ledger technology.” An asset class is one where securities are grouped together by characteristics. According to the Supreme Court, a security is an arrangement developed to profit from using other people’s money, in other words, anything that is tradable and intended to raise funds in return for potential income. Stocks, for example, are one kind of security, but not the only kind of security.
The securities in an asset class usually behave the same way in the market and are often regulated the same way. To be more specific, it’s generally agreed that there are four broad classes of assets. These are: 1) stocks or equities; 2) fixed income securities or bonds; 3) money market securities or cash equivalents; and 4) real estate, and real estate investment trusts (REITs) or other tangible assets.
Digital assets are investments, but the law and regulatory structure around them lacks clarity. As an asset class, the regulatory structure isn’t uniform. This makes the risk of digital assets higher than others. The lack of clarity and risk can be a fertile ground to discuss risk tolerance. The SEC recently reiterated that it will apply to the “investment contract” framework first set in the 1946 Supreme Court case of Howey to determine if a digital asset is a security (and therefore will be subject to certain regulations). The agency recently said an “’investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others….The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold.” The circumstance-based assessment removes clarity other assets may have.
Many who currently invest in digital assets mix them into their portfolios. “Among respondents who currently invest in digital assets for retirement, 38% of their total portfolio is allocated to them. More than half (53%) invest in cryptocurrency, and slightly less than one-third invest in nonfungible tokens (NFTs) or memecoins. Additionally, 15% of respondents who aren’t currently invested in digital assets revealed they plan to do so in the future.” This mix of digital assets into portfolios can be an opportunity to discuss risk tolerance and diversification.
Risk tolerance usually refers to the amount of loss an investor can handle. Risk tolerance is related to the amount of assets held, but it also involves fearfulness or anxiety. Risk tolerance is sometimes assessed by looking at an individual’s beliefs about risk through four factors: propensity, attitude, capacity and knowledge. Risk tolerance groups are often classified as aggressive, moderate or balanced and conservative. Usually, investors with a longer time horizon can handle more risk, usually related to chronological age.
Plan participants aren’t always the best judges of their risk tolerance. Many advisors say that their clients self-report risk tolerance based on market performance: a higher risk tolerance when the market is doing well and a lower tolerance when it performs badly. Importantly, risk tolerance changed by loss of a job, a health crisis, saving for family education.
When it comes to digital assets, plan participants may be using them as a way to diversify their investing. Whether that is appropriate or not depends on the individual, but overall, it makes for a good basis to discuss diversification. Simply stated, diversification is the practice of spreading investments around so that exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of a portfolio over time. But adding high risk assets, like digital assets, to a portfolio might not be the right answer. Instead, most investors may want to learn to diversify by asset class and by volatility of asset. “The primary goal of diversification isn't to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio.” By using digital assets as an example in their financial literacy programs, plan sponsors can help their plan participants better understand the basics.
Some financial professionals also include commodities (like gas, oil, wheat and minerals) as a fifth asset class.
These articles are prepared for general purposes and are not intended to provide advice or encourage specific behavior. Before taking any action, Advisors and Plan Sponsors should consult with their compliance, finance and legal teams.
Before leaping into the unknown, we recommend a thorough examination of your plan. Because we are experts in the field, we know the marketplace and know what your existing vendor is capable of offering. Through this examination, we can help you optimize the service you receive.get xpress proposal