For some financial advisors, identifying a client's risk tolerance can be a highly subjective and often inaccurate process. Even more confusing is the linkage between a derived risk tolerance level and the resultant asset allocation mix. With asset allocation software such as Sungard's Frontier Analytics Allocation Master or an investment research platform such as Morningstar's Workstation, a risk tolerance questionnaire is built into these programs to assist you in developing that linkage. However, one question is whether a ten-or 12-question scoring system is statistically significant (or sufficient) in determining and documenting a client's appropriate risk tolerance level. More to the point, can you use an effective risk tolerance scoring system with your practice that is both seamless and transparent to your clients?
The answer is yes. But the choices may depend on the way you work with your clients. The first and foremost consideration should be to protect the client (often from themselves). Using a system that accurately reflects your client's risk tolerance can protect the client. When the time comes (and it probably will) that the client wants to take more risk than is called for by the risk tolerance score, it necessitates a discussion and reminder on risk in general and the client's goals in particular.
A necessary second consideration is protecting you. Should you ever be subject to an NASD Arbitration Hearing (and I certainly hope not), one question could be to detail your methodology and documentation on identifying your client's risk tolerance (and to what extent that agrees with the investments in question). Therefore, having a system that can document your efforts to nail down a client's risk tolerance and educate the client on risk will help you during such a proceeding.
There is some argument, however, on the lengths one should go to determine a risk tolerance level. On the one hand, there has been groundbreaking work done on risk profiling by a number of eminent people. The resulting risk profile questionnaires can be quite daunting, with 50 or more questions, exercises, graphs and charts for a client to wade through in order to arrive at a number. On the other hand are the software packages that throw in a risk tool with ten or 12 cursory questions. Then there is the issue of differing risk scores between a husband and wife or significant others. How do we resolve such a conflict? And what effect does all this risk profiling have on the client's perception of you and the job you are doing for them?
Therefore a decision may need to be made: choosing asset allocation software that includes a risk assessment tool that could be less than adequate, or using an independent risk assessment tool and trying to make it work with the asset allocation software. This might turn out to be less difficult than it at first seems. One important point is that, regardless of how you decide to determine your clients' risk tolerance, it is critical to have a procedure that fully identifies the process, establishes the linkage to a portfolio and documents the client's understanding and acknowledgement.
One company that has attempted to take risk assessment to a more scientific and less subjective level is FinaMetrica (formerly ProQuest, www.finametrica.com). FinaMetrica offers a Web-based solution that permits the client to access its questionnaire online and receive an immediate score with an explanation. The advantage of a Web-based solution is the transparency issue; that is, the client performs the risk questionnaire outside of the financial advisor's office and at their own schedule. The results are available to both the advisor and the client. FinaMetrica seems to have gone to great lengths to develop a sensible questionnaire without being obnoxiously long-it contains 25 questions.
Speaking of subjective results, FinaMetrica founder and CEO Geoff Davey says, "Risk tolerance is a psychological trait, i.e. a relatively enduring way in which one individual differs from another ... So, while an individual will have a single risk profile (the relative strength of the psychological trait, risk tolerance), they may be following a range of strategies each of which has its own risk profile (level of risk)."
This could require different risk tolerances for different time horizons. In other words, a client might be less willing to take the same risks with a shorter time frame than with a longer one. As Davey explains, "For long-term goals, the issue is how the short-term volatility of a strategy which would achieve the goal compares with the client's risk tolerance. For short-term goals, however, in order to achieve the goal [with the desired certainty] a suitable strategy will need to be low-risk in the first place. So risk tolerance is usually not an issue."
This would suggest that a risk score is enduring and applicable to a client's entire financial situation, short-term goals not withstanding. However, other schools of thought suggest risk scoring is not enduring. Some question whether a risk score that was obtained from a client in 1997 would turn out to be the same if scored again in 2004. Therefore, periodically revisiting with your clients on risk and retaking the risk assessment questionnaire would at least confirm a client's risk tolerance or raise questions about changes in that score that should be addressed by the financial advisor.
From an efficiency standpoint, an online-type risk assessment system works well with clients who are comfortable answering questionnaires using the Web. For those who are not, simply printing out the questionnaire for the client to fill in is the alternative. But the handwritten versions are more labor-intensive for the financial advisor, and thus less efficient.
Another key element of efficiency in developing your risk assessment procedure is linking it to your methodology for developing a client's portfolio (i.e., asset allocation strategy).