This is the time of year when financial advisors typically meet with their clients to discuss the state of their financial plans and review any potential modifications or adjustments based on market events, big life changes or other important considerations. Invariably, this includes assessing whether their risk profile has changed significantly.
What advisors are increasingly finding is that there is frequently a significant disconnect between how much risk a client perceives they are willing to take conceptually versus what is tolerable in real terms. In large part, this is due to the structure and composition of most standard risk tolerance questionnaires, which are perfunctory, all too brief exercises that are riddled with shortcomings and which offer, at best, a vague and superficial view into a client’s mindset.
Because of this, many advisors inadvertently misjudge their clients. Moreover, if they partner with asset managers who have a check-the-box, risk tolerance-driven approach, their asset allocation and investing decisions can become overly homogenized, and thus far less likely to meet their individual clients’ needs. Even worse, mistakes and missed opportunities pile up over the years or decades, and portfolios suffer—all because the industry currently doesn’t have an adequate process in place to gain a full appreciation of a client’s risk profile.
Weaknesses
The main issue plaguing risk tolerance questionnaires is the way in which most of the questions are framed. A common question goes something like this: You bought into a fund at the beginning of the year. It’s dropped 10 percent since. Are you more inclined to sell, hold or buy more?
This question is nearly impossible to answer absent more context. Why did the fund decline? Is it heavily exposed to a sector that is currently beaten down but poised for a comeback? Or have fundamentals permanently shifted, and is it time to get out and possibly harvest those losses for tax purposes? Very few clients can sift through these issues effectively—that’s what advisors are paid to do. Far from providing more clarity, then, including this type of question is only likely to cause more confusion and yield an incomplete answer.
Another issue is that risk is variable, making it tough to measure a client's tolerance for it accurately. Many asset classes that were once considered ‘risky’ have been anything but in recent years. Conversely, some vehicles that were once ‘safe’ bets have been riddled with instability.
Consider commodities as an example. Fifty years ago, investors with a relatively low risk profile could have bought and held a bucket of various commodities for two decades and done quite well, experiencing strong, stable returns while having exposure to assets that were non-correlated to equities. Over the last 25 years, however, the very same investments were far more volatile and unpredictable, representing a great deal of risk.
Think About Goals, Not Risk
With all this in mind, financial advisors who rely on standard risk tolerance questionnaires—and by extension, third-party asset managers that develop solutions based on them—are doing themselves and their clients a disservice. Instead, these advisors would be better served to focus on putting together a goals-based plan.