Every advisor knows that when a bear market takes hold, many clients have the sudden urge to reassess their risk tolerance.

Quite suddenly, the courageous ability to withstand extremes in equities market volatility — sworn to by clients in “know your client” forms all across the land during the height of the preceding bull market — crumbles to dust in the face of true adversity. That’s what we’ve been seeing in the past few months as the snarling bear market reveals clients’ true risk-tolerance levels.

This is human nature, and advisors are familiar with the psychological phenomenon involved. That is the reason why “everyone’s a genius in a bull market.”

During times of market stress, many advisors seek to reassure wavering clients with the historical record, arguing that equities outperform all other asset classes over the longer term. The conclusion drawn for the client is that a buy-and-hold strategy inevitably bears fruit — given enough time. But when the market cycle kicks in on the downside, that argument rings hollow for clients who are just as capable of looking at a long-term stock chart.

For example, look at a long-term chart on the S&P 500 composite index and you can see that at the beginning of October, it was at precisely the same level it was 10 years earlier. By any definition, 10 years is “long term.” The compounded annual 10-year total return for the S&P 500 works out to about 3% (in U.S. dollars) for this period. Anyone holding the index through an exchange-traded fund or mutual fund would have had a return of approximately zero — and very probably even a negative return once taxes, inflation and exchange rates are factored in — over the “long term.”

Nevertheless, the long-standing view is that equity assets outperform all other asset classes over the very long term. Where reliable statistics exist (starting from about the 1920s), you will find that U.S. equities have outperformed every other U.S. asset class over almost every long-term period, regardless of what year you start in.

So, if equities are the best investment, from a total return point of view, why hold anything but equities? If the objective is to make as much money as possible, why not buy the asset class that historically pays the most?

There are two reasons: one, you should not do it; and, two, you cannot do it. Let me explain. Imagine for a moment that the highest-paying job in the world is that of a linebacker in the National Football League. Would you want to do that job? And even if you did, could you actually do it? Most people would say no. In fact, that’s why linebackers are paid so much.

Let’s get the discussion back a little closer to home. Yes, equities have the highest historical long-term return, but they also have the highest risk. That’s why, like the linebacker job, they pay more. It’s a question of variability of return over time; and over the long term, equities display far greater volatility than either bonds or cash. That’s why you shouldn’t commit 100% of a portfolio to stocks — even during the best of times. It’s common wisdom, it’s smart, it’s the right thing to do. But it usually hits home only during vicious market downturns.

Now, let’s turn to why you can’t invest 100% in equities in the first place. Despite a firm conviction that clients will be able to stay 100% invested in equities regardless of whatever the market throws at them, I humbly suggest — and this is based on experience — that most clients won’t be able to stay invested. They just won’t be able to handle the volatility of an all-equities portfolio.

Here’s a real-life example: from 2003 to the autumn of 2007, equities were zooming upward. During this time, quite a number of inves-tors professed to have a very high degree of risk tolerance. I was told more countless times that they could handle the risks of even the most aggressive equities portfolio.

So, what happened to these investors when the market tumbled? They began revising their risk tolerance downward because they discovered they could handle only upside volatility. Downside volatility redefined “risk” for them, as did markets falling by hundreds of points each day.

@page_break@In fact, clients’ risk tolerance never really changed. Risk tolerance depends on what you are comfortable with in the long term, regardless of what the market is doing. The investors I spoke to during the bull market overestimated their tolerance for risk in the early going because they focused only on the potential returns. In fact, if there’s a silver lining to be found in the current bear market, it’s that some investors have come to know what their risk-tolerance level really is.

An all-equities portfolio is out of the question. You can’t get all-equities returns without taking all-equities risks — and those risks can be high. If you can’t stay invested throughout, you won’t get the returns any more than you will get paid like a linebacker for being in the stands at game time.

So, where does that leave advisors? Thirty years ago, it used to be that a portfolio of 15 stocks was considered ample diversification. But as capital markets expanded and mutual funds became the “next big thing,” that all changed. We redefined equities diversification by looking at categorizing equities-based products by investment style, market capitalization, region, sector, and so on.

Today, the portfolio construction paradigm has shifted yet again. With a variety of securities available for every conceivable asset class, an appropriate asset mix has become the guiding principle of effective portfolio construction that meets the true risk-tolerance test.

You need a portfolio of diverse asset classes — including some equities, but weighted with other non-correlated asset classes as well — to get a decent, stable return, year in and year out, without taking on a level of risk inappropriate for a given client. Portfolio diversification across a variety of asset classes reduces the volatility inherent in an all-equities portfolio.

In addition, a healthy cash flow stream from an allocation toward income-producing assets, or from tactical use of cash-producing derivative strategies such as options writing, provides ballast to counterweight underperformance in equity allocations and a boost to longer-term portfolio performance through reinvestment of that cash flow.

Does it work? Take a look at recent one-year performance numbers for the FPX balanced index, one of three indices I co-developed a few years ago with Eric Kirzner. This index tracks a “real world” balanced portfolio comprising 10% 91-day T- bills, 40% Government of Canada bonds and 50% passive equity domestic and foreign index funds. The results to Oct. 6 speak for themselves: the S&P/TSX composite index was down by 30.9% over the previous 52 weeks, vs a decline of 10.5% for the FPX balanced index.

Instead of the unpalatable “all or nothing” choice the all-equities client faces in times of market turmoil, the balanced portfolio approach allows wide latitude for rebalancing when allocations become distorted. In other words, the client stays invested and participates in the inevitable market recovery without attempting to pinpoint the best re-entry point. IE