A plan for achieving each goal should be developed by taking into account client assets, liabilities and time horizons. By linking goals and constraints, you will keep your advice grounded in reality, build trust and keep yourself from making recommendations that show you did not take the time to understand the client’s unique situation and needs.
Preferences. Then there is the challenge of discovering and cataloging a client’s preferences. “Preferences,” in this context, is an umbrella term that includes emotional and cognitive characteristics that affect how the client perceives the world and makes decisions. Understanding preferences improves your ability to provide advice a client can live with.
Capturing your clients’ preferences requires creation of a “behavioral portrait.” This is hard work. Many advisors have a passing familiarity with the basic concepts of behavioral finance, but few have an in-depth knowledge of this topic and even fewer are trained psychologists. For the most part, advisors are left to feel their way toward understanding client preferences because there is a dearth of tools with a solid scientific foundation to help in this process.
A Behavioral Portrait of Each Client
The industry has traditionally used risk tolerance questionnaires to create behavioral portraits of their clients. Until recently, these were the only tools advisors had available, and they have become quite pervasive. But research has shown that questionnaires have a number of inadequacies.
First, “stated preferences” about risk tolerance are not particularly reliable. Clients are notoriously bad at understanding and reporting their own risk tolerance. Many don’t even understand the concept, and so have difficulty responding meaningfully to questions about their own behavior. What’s more, their tolerance changes over time.
The practice of assigning a client to a portfolio given only their risk tolerance is becoming commonplace, but it’s suboptimal. Focusing on risk without considering client goals and constraints is an unbalanced approach. It’s like trying to make a suit for a person whose height you know, but whose waist and chest size you don’t.
Another problem with designing a portfolio this way is that risk tolerance is only one aspect of a client’s risk persona. There are four aspects, and each needs to be considered in advising the client.
The first is their “risk requirement”—that is, the amount of risk they should be taking if they want to reach their stated goals. If they have $500,000 today and want $1 million in 10 years, you will have to calculate the amount of risk they must assume to stand a reasonable chance. It is essentially a math problem.
The second is “risk capacity.” That means the amount of risk they can afford to take given their current constraints on time and financial resources. Theoretically, clients with aggressive goals, few financial resources and a short time horizon should take lots of risk to have any mathematical chance of reaching their goals. But realistically, they probably shouldn’t. Given their narrow time horizon, they simply don’t have the capacity to recover from significant losses, which are a distinct possibility if they pursue aggressive investment strategies.