The Real Risk
Maybe the biggest risk is in believing that these risk tolerance questionnaires unearth anything other than whimsical answers revealing only how an individual felt at the time. Based on those slight indicators, you create an investment plan, your clients sign off on it and then they call you in a panic, brew silently or switch advisors when the low-end realities come into play. Now, that's risky business.
How can we do better?
By accepting the reality that two or three risk assessment questions will provide false indications or transitory indications at best, I suspect that safer, more credible inquiries can be discovered in a client's personal history or his personal financial philosophy. How much risk an individual will tolerate hinges more on past experience than on predicting a future response. The following are issues I believe to be germane to the risk tolerance discussion:
1. The clients' personal experiences (both positive and negative) in the arena of investments. What happened, how did it happen, whom do they blame or credit, and what conclusions did they draw from these experiences?
2. Their personal philosophy on financial matters. What guidelines do they follow regarding financial and investment matters? Do they have guidelines, or do others make these for the client? What are their boundaries regarding debt, assuming risk and trusting others? In short, what is their "fiscalosophy?"
In the interest of space constraints, I will offer some suggestions in this article on item one (their experiences). I will deal more extensively with item two (financial philosophy) in my next column.
Speaking From Experience
1. What positive experiences have you had with investments, and how did they come about?
2. What disappointing experiences have you had, and how did they happen?
3. What kinds of investment concepts are you simply not interested in?
4. What guidelines or rules do you attempt to follow regarding managing your money and investments, and how did you learn these guidelines?
5. What sort of experiences have you had with other financial professionals?
6. What are your expectations of a financial advisor?
7. What are your hesitations about working with a financial advisor?
I would venture to guess that you will obtain a much clearer portrait of a client's tolerance for various investment suggestions through this type of inquiry than you ever will through the instruments applied universally in this industry. Furthermore, I suspect that your clients' stories will indicate much more about how they might behave, given a set of future circumstances, than a pencil mark designating "conservative," "moderate" or "aggressive" would ever hope to tell us.
An advisor came to me the other day and told a story that affirms my suspicions:
"My partner and I were getting ready to sit down with a prospect who had a considerable amount of money. My partner had put together a plan for allocation that was moderate in risk but included some exposure to the technology sector. This fellow's risk indication had come in as moderate, and so we thought this would fly. At the last minute, just before we were to show him our suggestions, I decided to do what you recommended, and dig into a little of his investing history. I asked him what his 'best and worst' investing experiences had been. He talked, with vivid emotion, about being badly burned, and concluded with firm resolve, 'I'll never put another penny in tech.'"
Oops.
This advisor found out the real risk in dealing with a client's risk level-not knowing the story of how the client came about his or her opinions and tolerances.
The other risk would be using a test for risk that simply doesn't work.