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.

For most people, it’s difficult to take the emotion out of investing and consider risk on an intellectual level. This is highlighted by the fact that two of the most common mistakes made by investors are selling at the first sign of volatility and having too much cash sitting on the sidelines. The emotional pain associated with the prospect of losing money simply overwhelms the rational side of their brain.

By developing a long-term, goals-based plan, however, advisors can help clients keep risk in perspective. In truth, most investors want the same things, and they’re all pretty simple: to educate their kids, have a relatively comfortable lifestyle and live well in retirement. Advisors should work to help clients focus on these overarching goals, not whether they are content with the level of risk they are taking.

Think about a doctor treating a sick patient. Do they ask them how they feel about taking a particular medication? Almost never. They diagnose the problem, provide a prescription and tell them what they need to do to get better. Advisors need to have the same mindset—it’s not about what clients feel like doing, it’s about what is best for them.

Ultimately, a client’s comfort level with risk is one thing. What they need to do to achieve their goals may be something entirely different, and it’s rare when the two are in alignment. And that’s the essential irony of the risk tolerance questionnaire construct: Even though it was put in place to protect advisors, the reality is that it may increase the likelihood of a client initiating an arbitration hearing or some other legal action when things don’t turn out like they envisioned.

Advisors, though, can position themselves to avoid those potential outcomes by reducing their dependence on poorly worded, off-the-shelf risk tolerance checklists and refocusing that effort on understanding clients’ needs to help them implement goals-based plans.

Greg Luken is founder and CEO of Luken Investment Analytics, a turnkey quantitative research and asset management firm that enables financial advisors to deliver innovative asset allocation strategies to retail investors. He can be reached at [email protected].