Wise advisors understand they must often make difficult trade-offs to align their clients’ risk appetite with the resources they have at their disposal to achieve client goals. Advisors also know that the appropriate actions can change with clients’ appetites and as time and events unfold.
Unfortunately, this process is hampered by risk management tools borrowed from other areas of financial services and developed for purposes not completely aligned with the role that RIAs perform. These tools are not much different from those developed 25 years ago for the broker-dealer trading desks to manage their inventory, and which were then adopted by hedge funds and asset management firms facing similar risk concerns. The tools more recently found their way into the RIA and wealth management space.
Inappropriate For The Mission
But they aren’t appropriate for the RIA’s (the advisor’s) mission. Where the banks and hedge funds are focused on monthly or even daily variability in their profit and loss statements, the time horizon of an advisor’s client is measured in years or even generations. Where the bank demands risk management for reasons of control—as a check and balance for optimally offsetting positions, largely for its own exposures—the advisor’s need is to work collaboratively with clients on their assets. Standard risk management casts a rigid and unyieldingly quantitative light on P&L (as befits its bank origins) but the advisor has a textured, multilayered objective in meeting the long-term goals of clients.
In other words, advisors face human clients with human goals, goals that change with the passage of time, with the ups and downs of their portfolios, and with (often unexpected) life experiences. No matter how detailed a model of the market might be, advisors instinctively understand that the picture will be incomplete unless the model sees the client as agent. The portfolio will not and should not be the same in the future as it is now.
For example, take a path that lands at a point where the markets have dropped significantly, and the client has a shortfall in the resources they need to make their goal. At that point, being closer to the time horizon for their goal, there is less time to catch up. The advisor will likely understand that the client’s risk capacity has changed, and with it the client’s tolerance. Very often, of course, the financial objectives themselves will change as well. And since the client is no longer on the path sketched out before, the portfolio should change.
What is more, these changes can feed back into the market. The market’s behavior in the aggregate is determined by the ways individuals interact with it: People respond to market performance, and the market, in turn, reflects the aggregate responses of market participants. There is a complex, nonlinear dynamic at work.
Advisors know not to stand fast with a client’s current portfolio and original goals, assuming these will work in all future worlds, but rather to be flexible and react to shifts in portfolio value, a client’s risk tolerance and capacity. Ideally, advisors should not need to be reactive, they should not need to wait for the future to become obvious before amending a plan. Yet that’s exactly what advisors are forced to do with the tools at their disposal today: to redo their analyses and portfolio strategies after the “future” has already occurred.
Bringing A Knife To A Scissors Fight
A client’s risk has to be cut with scissors, not with a knife. One blade responds to market uncertainty, the other to disruptions, or even just desired changes, in client goals. Advisors are navigating a path, not a point in time. They are pursuing a moving target, and thus demand an approach that is nimble and flexible, one that allows midcourse corrections along the way.
And this shouldn’t be news to them. Advisors marry market realities to client goals. But they are being handicapped because the risk systems they use do not do the same. And given the origin of these models, they should not be expected to. With the advances in modeling methods, computer technology and sheer computing power, advisors can now incorporate risk management in a more effective and comprehensive way.
Building A ‘Culture’ About Risk
Risk means something different to clients than it does to traditional portfolio managers, banks and insurance companies. It’s not really about numbers to clients, nor is it about returns or standard deviations. It’s instead a part of a vibrant life. Not really something to be avoided. It’s a framework of possible outcomes that can be used in pursuit of a desired result. In the best advisory relationships, advisors and clients, together, understand that this involves careful pondering of questions such as these:
• Should I look to move when I retire, and what will that mean for my current friendships and continuing to have a fulfilling life?
• Which college should my child go to, and how much do I need to save to afford it? And how will our emotional relationship change as my children become independent and live away from home?
• What are the many dislocations I need to worry about if I take that new job overseas?
• If I accept the offer to join the board of the ballet company, can I really afford the time commitment … not to mention the expected financial support?
There are, of course, thousands of conversations that advisors will have about risk with their clients … since life’s risks have a living, dynamic complexion. Risk doesn’t just “happen” to people. It is very often of people’s own creation, a part of positive life opportunities and experiences the client chooses to take—things they embrace, not avoid.
Where Software Often Fails
These are not things that boil down to inputs that easily fit financial planning software. The risks we face in life might have financial implications embedded within them, but to look at them only through a financial lens often means missing life’s richness, as well as the richness of the objectives. For example, that new job overseas may not be really about the money. The emotional impact of the kids leaving the nest may be what’s really most significant.
In many cases these life experiences can’t be planned for in advance, much less thought of within the initial financial plan. Sometimes, they are surprises that come out of nowhere. So they need to be integrated into the financial advisor’s rich, ongoing discussions. These discussions not only benefit the client but enhance the advisor’s own career fulfillment. The learning never stops; the professional gratification of providing sound advice has no limit.
Just as risk is at the core of life experiences that are never entirely financial, so the advisory/client communication must not shy away from identifying the elements of risk that those experiences present.
Speaking the same language about risk. When risk is at the core of communication, the advisor and the client come to look at it and speak about it the same way. They can communicate about how risk is higher or lower, what might lead risks to change, what is the right risk tolerance for the client given the risk capacity, and how that might change. That communication won’t be put only into numbers, but also (more importantly) into narratives. Those narratives will involve the way a variety of risks become part of the clients’ optimal choices throughout their lives. And to bring in the financial element, that language must be rich enough to also express the complex dynamics of the investment markets, taxes, inflation and other financial policies. The language about risk must have a broad and deep vocabulary.
Understanding the client’s purpose for taking risk. When advisor and client share a common risk language, they are more likely to understand the achievability of client goals and agree on the available and appropriate path. The advisor knows there will be bumps in the road that will matter to the client. And there will be others that won’t be significant and can be largely ignored. The risk conversation is a narrative describing these twists and turns, the ups and downs along the way.
Integrating the client’s values that are encompassed by risk. When advisors understand the clients’ reasons for taking risk, they are more likely to see eye to eye on what values are important to the clients and view risk in that dimension. The client might want to pursue environmental, social or even political issues. They might desire respect within their communities. They might want to protect their family from financial hardship over future generations. There are no limits to the range of client motivations, but each of them could pose a different set of risk criteria.
‘Risk Culture’
Purpose and values, and the language used to express them, are the elements of culture. So when we combine these elements in the advisor-client relationship, we should have a culture of risk assessment and management—a common framework that adds depth to the relationship, makes it genuinely human, not mechanical, and puts risk in the forefront rather than merely inside a box to check off or a number to report.
Risk is part of life, not something separate from it and, in no small part, it’s a human creation, a natural part of decisions we make. Within the RIA industry, a key component for relating to that reality is creating a culture of risk discovery, assessment and management. That culture should permeate both our firms and the relationships between advisors and their clients.
Rick Bookstaber, Ph.D., is founder and head of risk at Fabric. He previously held chief risk officer roles at Morgan Stanley, Salomon Brothers, Bridgewater Associates and the University of California Regents and served at the U.S. Treasury in the aftermath of the 2008 crisis. He is the author of The End of Theory (Princeton, 2017) and A Demon of Our Own Design.
Tim Kochis, JD, MBA, CFP, is advisor to and an investor in Fabric. He is co-founder and former chair and CEO of Aspiriant. He previously led personal financial planning at Deloitte & Touche and Bank of America. Kochis chaired the CFP Board, the Foundation for Financial Planning and the Financial Planning Standards Board. He co-founded the Personal Financial Planning program at UC Berkeley and has written several books, including Managing Concentrated Stock (2d Ed. Bloomberg, 2016).