For the first 20 years of his career, Jim King used risk tolerance questionnaires to match clients with suitable investments. That changed with the 2000-2002 bear market that followed the dot-com crash. "A client might have said he could take a 20% drop in account value," says King, who heads a financial planning and investment advisory firm in Walnut Creek, Calif. "But guess what? Fear took over. Those questionnaires didn't indicate how clients would feel in the midst of turmoil."
Similarly, Brent Brodeski, principal and CEO of Savant Capital in Rockford, Ill., asserts that the advisory business tended to be "naive" about risks 15 years ago, at the beginning of the recent spate of boom and bust cycles. "When discussing risk," he says, "we'd point to the Ibbotson charts on the wall. We'd tell clients, if you're in for the long term you can expect annualized returns of 10% in stocks, 12% in small caps and 5% in bonds." The more volatility clients could stomach, the higher the expected returns.
Reassessing risk. Fast-forward to 2012, after a decade-plus in which clients have seen innumerable rounds of irrational exuberance and merciless comeuppance, culminating in the stock market crash in 2008 and 2009. Savvy advisors have recognized that investment risk needs a more sophisticated examination.
"In our approach to asset allocation and risk tolerance, we definitely have seen an ongoing evolution accelerated by, though not caused by, the financial meltdown," says Russ Hill, chairman and CEO of Halbert Hargrove, an RIA advisory firm in Long Beach, Calif. "For example, we increased our internal capacity by forming an investment committee seven to eight years ago. This pulled us away from product providers' information, which had largely become a sales tool. That is, risk tolerance equals, 'I know you and you can trust me. I show you a modern portfolio theory pie chart and make a sale.' Rinse, repeat."
Simplistic risk tolerance questionnaires may not be capable of addressing all the risks facing today's investors. Mike Martin, principal and CIO at Financial Advantage in Columbia, Md., lists no fewer than five kinds of investment risk. Leading off is inflation risk: as Martin puts it, the high probability of a loss of buying power means that most people must invest instead of stashing cash under the proverbial mattress, and thus expose their assets to all the other types of risks.
Most advisors are familiar with three of the other risks, those specific to issuers, valuations and macro-economic factors; after the turmoil of the 21st century, so are most clients. To these, Martin adds the fifth, systemic risk-the chance that a world built on paper currencies, fractional reserve banking and liquid global markets for debt and equity securities will seize up and pound portfolios. "That's the greatest risk of all," he says, "and the one hardest to defend against."
As the definition of investment risk expands, advisors may seek more precise ways to grapple with multiple challenges. "We look at risk-related measures such as the Sharpe ratio to see how our clients' risk-adjusted returns compared to riskier portfolios," says Stephanie Lang, director of the investment department at Homrich Berg, a wealth management firm in Atlanta. "This allows us to see if taking on more risk was rewarded." If the risk seems to justify the potential payoff, Lang's firm will look for pockets of opportunity within broad asset classes to possibly provide extra return.
To measure risk now, Hill says, his firm uses the financial risk profiling method offered by Australian company FinaMetrica. "It's simple and seems robust," says Hill. "We require that it be redone every year as part of our annual report process."
The FinaMetrica test is more detailed than most risk-tolerance questionnaires. Respondents fall into one of seven categories. So a Halbert Hargrove client in, say, FinaMetrica's Group 5 might have a different asset allocation than a client in Group 3. But the actual allocation is based on client goals, objectives and needs-not on their risk tolerance scores.
"If the score diverges a great deal from our assessment of a portfolio that can realistically achieve what the client needs," says Hill, "it could prove a limitation." The likely result, according to Hill, would be a substantive discussion with the client about the necessary trade-offs and the differences among various risks, such as volatility risk and shortfall risk.