05 Dec Why It’s Not Enough To Know A Client’s Risk Tolerance
It’s almost universally accepted by advisors and prescribed by regulators (e.g. FINRA, FCA, and MFDA) that advisors assess a client’s risk tolerance before recommending investments. Knowing how much risk someone is willing to take is essential in building a suitable plan. However, assessing someone’s risk tolerance is only one part of the puzzle.
Smart advisors assess other key client characteristics like goals and a client’s risk capacity (definitions here) but they should also assess a client’s ability to “stay the course”. Risk tolerance, risk capacity and goals are not enough.
Critiquing Risk Questionnaires
The number one critique of risk questionnaires is their inability to assess if a client will want to “sell at the bottom of a market correction”. This critique is largely unjustified because all risk questionnaires are not created equally. Those with robust underpinnings, rarely suffer this fate.
Additionally academic research has increasingly supported the idea of two psychological risk constructs. Risk tolerance is how much risk someone is willing to take based on objective outcomes and risk perception is the perceived risk of that decision. As Larrick said in his paper “Motivational Factors In Decision Theories” – 1993 – “it seems obvious that people’s preferences may depend not only on how they value objective outcomes but also on how they feel about risk.”
Risk perception explains why someone says they are willing to invest in an 80/20 stock bond portfolio and live through a 30% drawdown. But don’t want to do it in March 2009 at the bottom of the financial crisis. Their risk willingness is high, but their perception of the risk at that moment is also high because of the context of the decision.
What’s An Advisor To Do?
New research is always being developed in this area but a well cited older paper from 1997 by Robert A. Olsen’s “Investment Risk: The Experts’ Perspective” should interest you.
Olsen surveyed a group of professional portfolio managers and wealthy individuals who managed their own account. He was attempting to discover the risk characteristics people most cared about when investing.
He learned people cared about four attributes:
- The potential for a large loss
- The potential for a below target return
- The feeling of control over an investment
- The investor’s perceived level of knowledge
Looking at Olsen’s results we can conclude high quality risk profile questionnaires will help advisors assess a client’s ability to stomach a large loss or deal with a below target return. However, most don’t do anything to give clients a sense of control or education.
If you want your clients to stay the course they must feel like they have control over their investments and they must be educated. You can’t simply use a risk questionnaire, apply the results and then stop discussing risk with your clients.
Giving clients control can be achieved by ensuring they have easy access to their accounts and transparency about objectives and performance. Education is best done at account opening and over time with a regular newsletter.
In order to build a successful investment plan for your clients they need to stay the course as markets move up and down. If they are to stay the course you must not only know their risk tolerance, risk capacity and goals. You must also give them a sense of control over their investment fate and education. Education in particular is critical because it’s the best mechanism to stem the noise of the financial news media.