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.