Use A Risk Tolerance Questionnaire To Determine Portfolio Structure
Enter your assets, fill out a questionnaire and voila, the best portfolio mix for you will be created. Man, it would be great if it were that simple.
Most risk tolerance questionnaires have no scientific validity but even those assessments that are validated, can be overhyped by my definition. They are often presented as critical to getting the portfolio right, but I do not see them as critical to client success.
Clients don’t just need to know what to do. They must actually do those things to be better off. The portfolio mix isn’t “right” if clients won’t stick to the plan. That means hand holding in tough times or countering FOMO (fear of missing out) in good times.
There can be a significant discrepancy between what a risk tolerance test says, what a client says and how the portfolio needs to be structured to achieve a goal. These differences compound when working with couples. At the end of the day, compromises between what the client wants and what the client needs must be negotiated. The discomfort that can come from these differences is sure to manifest so planners must be prepared to coach clients to deal with that.
I have not seen a risk tolerance questionnaire that leads to a significantly different outcome than simply asking clients what they want, what they fear, what they have owned, and what they have done in past bad markets and then having a good conversation about risk. It pains me to say that because I am a bit of a research junkie and would much prefer something more scientific but so far, I haven’t seen any evidence that a particular risk questionnaire, sans the conversation and coaching, produces better outcomes than other questionnaires.
Now, I don’t think it is a bad thing to use a questionnaire to get the conversation going but clients’ success comes from a quality risk conversation, a sound portfolio design and ongoing behavioral coaching, not by matching a portfolio mix to a score on a questionnaire.
Add Alternative Investment Products To Portfolios
“The multi-billion-dollar endowments own alternatives so you should too.” Rubbish. To start, a client with a couple million bucks typically doesn’t have access to the same programs the endowments do. Moreover, the goals, temperament and resources of such clients have little, if any, resemblance to such funds.
Higher costs, greater dependency on management’s crystal ball, less transparency, low tax efficiency, and limited or no access to the funds, all make alternatives unattractive. These negative qualities are not outweighed by the purported benefit of low correlation. Low correlation is only a benefit if the return of the alternative’s zig is big enough to counteract the rest of the portfolio’s zag.