For too long, financial advisors have been making asset allocation decisions for their clients according to a “risk score,” a figure developed around client questionnaires to determine how much risk they can tolerate. But this approach often results in portfolios that are disconnected from actual client goals and are unresponsive to changes in clients’ financial situations. As a result, investors are not receiving truly personalized portfolios. That leads them to sub-optimal outcomes—and a much bigger risk that they won’t meet their goals.
In our research, we’ve gathered evidence for and become advocates of something different—an “investment policy process,” that balances the crucial elements of a client’s time horizon, risk tolerance, cash flows and return objectives, using them to create a dynamic, ongoing strategy that adapts in real time to their changing lives and market conditions.
Risk Scores Dominate Everything
According to the CFA Institute, an investment policy statement should be “a written document that clearly sets out a client’s return objectives and risk tolerance over [their] relevant time horizon, along with applicable constraints such as liquidity needs, tax considerations, regulatory requirement and unique circumstances.” The three pillars of the clients’ investments, then, are their required rate of return, risk tolerance and time horizon.
Yet when it comes to financial planning and building a client’s portfolio, pretty much one component dominates everything: risk tolerance! Both the required rate of return and the time horizon are treated, at best, as poor distant cousins in the discussion or at worst banished like Harry Potter to a closet under the stairs. The complexities of the client’s life get boiled down to a single number: the dreaded risk score, which ends up being virtually the exclusive determinant of their asset allocation, and arguably one of their portfolio’s most important characteristics.
The Dangers Of Relying Too Much On A Risk Score
On the surface, boiling a client’s risk tolerance down to a risk score may seem alluring. It’s easy to both understand and communicate. But it also fails to take into account the nuances of a client’s needs and circumstances. Using a risk score to build a client portfolio essentially nullifies an advisor’s great financial planning, throwing all that work out the window. The resulting portfolio is completely disconnected from the client’s financial plan.
Among the other problems with this approach is that clients with vastly different circumstances can end up owning the same portfolio—all because (wait for it) the risk score is the same. A 25-year-old should invest aggressively because of her circumstances, not because of her personality. She has 40 years until her drawdowns really matter for her consumption goals. A 75-year-old should invest more conservatively because of her needs and circumstances: Her near-term losses can’t necessarily be recovered from her nest egg as it is being consumed.
Yet both of these clients can end up in a 60/40 portfolio if they have the same risk score, in which case their differences become irrelevant.
Besides these obvious flaws, a litany of behavioral finance research studies have emerged pointing out more flaws in the risk-scoring approach.
The Behavioral Backdrop
There are myriad well-documented behavioral issues involved in risk-tolerance questionnaires and the scores that result. Risk scores, for one, fail to distinguish the degree of risk tolerance on a granular or individualized level (even if we accept the concept of volatility as risk). That means most clients end up in the “moderate” risk tolerance bucket. The result is a one-size-fits-all approach—the polar opposite of the customization that clients demand and advisors want to offer.
Everyone claims to be a long-term investor until they run into their first patch of poor performance, when they suddenly become obsessively interested in today’s/this week’s/this quarter’s returns. We call this poor emotional time travel.
The Solution
The alternative is to connect the client’s financial plan (not the risk score) to a custom portfolio. Instead of defining risk as volatility, we should define it as “not having what you need, when you need it” and then build portfolios to minimize that risk. This is a significant leap forward for goals-based wealth management.
We believe that an investment policy process that better balances a target return, the time horizon and risk tolerance will lead to better outcomes. We combine that process with our platform at Nebo Wealth using our pioneering portfolio optimization engine. The platform lets an advisor build a perfect-fit portfolio for each client at every stage of life. This is all done in an open architecture platform allowing you to use your own firm’s capital market assumptions and preferred investment building blocks (ETFs, individual stocks or mutual funds). If your client’s goals and objectives change, their portfolio will seamlessly evolve too. You no longer need to rebalance to a static allocation. Instead, you reoptimize according to the dynamic nature of the capital markets and client circumstances through a systematic, repeatable process for a new perfect-fit allocation.
A Leap Forward In Goals-Based Investment Management
Financial planning tools have done a great job of helping advisors build out the cash flows necessary to achieve a client’s long-term goals. But these tools have also ventured into the world of asset allocation. And here, our view is that they fall woefully short. Again, the client’s risk score has ended up being the primary determinant of a client’s portfolio, and we think there’s a better way.
James Montier, a behavioral finance expert, is the senior investment strategist, asset allocation for GMO. Martin Tarlie is the product lead for Nebo Wealth. Matt Kadnar is the sales lead for Nebo Wealth.
This article is an abstract of a recently published white paper, “The Perils of Outsourcing Asset Allocation to a Risk Score.” To read the full report, download at www.nebowealth.com/theory/the-perils-of-outsourcing-asset-allocation-to-a-risk-score.