When people win, they like risk. When they lose, they hate it. If only it were easier to translate that knowledge into an investment strategy or an asset allocation plan!
Since the market meltdown, investment advisors have been searching for better ways to measure how much risk really makes sense for each client. Some swear by a particular risk questionnaire; others rely on free-ranging dialogues, while others are no doubt completely at sea.
It's an important issue because many clients expect their advisor to intuit how they feel about risk, even if they can't express it. After losing a quarter (or more) of their portfolios' value in a few harrowing months, many clients who once considered themselves "very risk tolerant" are angry, disillusioned, and distrustful.
I can't help thinking that it represents a tremendous opportunity for financial professionals who are skilled in listening carefully to clients, building a strong bond with them, and creating a plan that meets their financial and emotional needs. As part of this process, each client's risk tolerance needs to be more accurately assessed. But how?
The Three Faces of Risk
"A lot of risk questionnaires are built wrong in general, asking the wrong questions and getting the wrong answers," Michael Kitces told me. Kitces, who is director of research for Pinnacle Advisory Group in Columbia, Maryland, and publishes The Kitces Report, has done a great deal of thinking about risk tolerance.
He argues that there's more than one piece to this puzzle. The obvious piece is risk capacity, which is based on the client's financial situation. Advisors are typically familiar with the factors that influence this assessment, such as length of time to retirement, availability of guaranteed income, ability to self-insure for long-term care, and so on. With Monte Carlo projections, it's possible to estimate how much investment risk the client needs to take to improve the odds of attaining his or her goals.
However, there is often a disconnect between one's liking for risk and one's financial capacity to bear it. For example, a client may insist that he wants to take no risk at all, even though risk-taking is his only hope of achieving his goals. Or you may encounter the opposite, as Bobbie Munroe, a planner and owner of Fraser Financial in Atlanta, points out: "Sometimes a client is well prepared for retirement because they have a high risk tolerance and invested somewhat aggressively during the accumulation phase. As they enter retirement they might not need to take much risk, as all their goals are provided for. Following their prior style could be the only thing that would jeopardize their plan. Yet they still want to take risk."
This disconnect can easily happen, Kitces observes, when a questionnaire mixes queries about risk capacity with others about risk attitude (people's willingness to accept the potential fear and anxiety that accompany risk). After combining these questions, they average the scores to come out with a nonsense number.
For example, suppose you have a client with a very low risk attitude. If his portfolio were exposed to so much risk that it lost 20%, he would feel like jumping out of a 10-story building. Yet if this risk-averse client has a high risk capacity, a flawed questionnaire might average the two and recommend that he take moderate risk. Will he feel better if his portfolio loses only 10%? Maybe he'll only want to jump out of a five-story building!
In order to determine how much risk a client can handle, it's essential to differentiate risk capacity from risk attitude and explore these two domains separately. "Don't ever give them a portfolio that crosses the line into fear and anxiety they can't tolerate," Kitces warns. Advisors who disregard this rule tend to end up being either abandoned or even sued by unhappy clients.
Risk's Changing Contours
There is a third piece of the puzzle that Kitces identifies: risk perception, which gauges how clients view the riskiness of various kinds of investments. Risk perception changes frequently (and sometimes irrationally), depending on whether markets are up or down and what sector is hot at the moment. For example, during the technology bubble of the late 1990s, even risk-averse clients wanted to invest heavily in tech stocks. Why? Because they perceived that these stocks weren't risky at all.
An advisor's education and communication skills can be instrumental in changing risk perceptions over the life of a relationship. A good advisor would have educated his or her clients that tech stocks' wild upswing didn't make them safe. More recently, clients riding the long bull market needed to be educated about the risk of falling short of their goals if the market imploded.
As Kitces puts it, "Because we are not terribly rational, and because we have lots of biases that constantly cause us to misjudge risk, in a bull market clients think that being 100% in stocks is safe and that stocks will go up forever. In a bear market, they think that stocks will probably go down to zero. Both are totally irrational and untrue." This flipflop is not due to a change in the client's risk attitude (which Kitces believes is fairly constant), but to a shift in risk perception based on current trends.
John Comer, president of Comer Consulting in Plymouth, Minnesota, a marketing consultant to financial planners, cites a personal example of the changeability of risk perceptions: "I used to live in Brooklyn, New York, and felt very comfortable in the neighborhood. One day I was mugged coming home, and from then on I started to look over my shoulder as I walked through the neighborhood. A lot of your clients feel like they have been mugged, and they are looking over their shoulder more than they did two years ago."
One of the advisors Comer works with had a similar incident with one of his clients. The client originally came into the relationship insisting on conservative investments, due to issues with a previous advisor. However, over five years of strong markets he became disenchanted with his portfolio's meager returns. Of course the financial advisor said he could adjust the mix, but it was too late. The client left.
As therapeutic educators, financial advisors have to continuously manage clients' expectations and fears in order to counter what Kitces calls (with a nod to Alan Greenspan) "the irrational exuberance of bull markets and the irrational fear of bear markets." To ascertain their present risk perceptions, you need to ask them frequently, "How risky do you think the stock market is these days?" and "What do you think of your portfolio?" Even if you've determined their risk attitude (and risk capacity) previously, they may be misjudging the current amount of risk in their investments. That's where the job of educating them beyond their prejudices, fears, and irrationalities comes in—a long-term, ongoing process.
Kitces concludes, "If you find your clients' behavior around risk is constantly changing, you're probably not doing enough communicating and educating to help them move to more rational attitudes."
In short, don't get so wrapped up in the back end of the process—creating a reduced-risk portfolio for your clients—that you overlook the front end, which is learning how they feel. As Karen Hube noted in a September 2, 2009 article in The Wall Street Journal: "Some advisers are dumping targeted investments and choosing broad index funds, and others [are] stepping up their tactical bets. That echoes the perennial debate over whether to take a passive or active approach to investing, says Deanna Sharpe, associate professor of personal financial planning at the University of Missouri in Columbia...More important than classifying a planner as an active or passive investor, Dr. Sharpe says, is 'actively managing your relationship with those managing your money.'"
Managing Investments, or Investors?
Kol Birke is already on that wavelength. He tells the advisors he works with, "You need to start breaking out your management of investments from your management of investors." A financial behavior specialist in the home office of independent broker/dealer Commonwealth Financial in Waltham, Massachusetts, Birke defines his mission as arming advisors with the tools to help their clients lead their best lives. To better manage investors' vulnerability to risk, he suggests that advisors coach them on three levels: learn, prepare, and deploy.
Learn about your clients' style as investors. Are they risk avoiders, risk-takers, or in between? How do they handle stress? How hands-on do they want to be in choosing investments? How do they prefer you to communicate with them?
Prepare them for tough times. If they've experienced a rough financial period in the past, what helped them get through it? What do they know now that they wish they'd known then? Would they like you to remind them of that wisdom if tough times roll around again? The process of helping clients harness their own resilience is an excellent and oft-forgotten piece of the relationship. It may help you counteract a client's later tendencies toward panic, paralysis, or rash action.
Another part of "Prepare" is helping clients develop what Birke calls a "non-financial emergency fund." Ask what resources they have to draw on in a stressful situation: friends, family, pets, community, faith, creative outlets, physical activities? Provide resource lists to assist clients in building up this "fund."
Deploy these resources if your clients encounter challenges. In tough times, they'll be able to draw not just from their financial accounts, but from this non-financial emergency fund as well.
Birke and Tere D'Amato, VP of advanced planning for Commonwealth, believe that investment risk management needs to consider three factors: risk capacity, goals, and style. Capacity is "what I have," not just assets and liabilities, but the predictability of income, the amount of emergency cash, the number of dependents, fixed and variable expenses, the adequacy of insurance coverage.
On the other side is "what I want": the goals the client hopes to fund. In defining these goals, Birke reminded me of Barry Schwartz's excellent book about decision theory, The Paradox of Choice: Why More Is Less (Harper Perennial, 2005). In Schwartz's terminology, people tend to be either maximizers, who want only the best, or "satisficers," who are willing to settle for good enough. Birke feels that maximizing is most people's default behavior. I agree: in our endlessly expansive, all-too-acquisitive, short-term-oriented culture, many people believe "more is better" instead of saying to themselves, "what I do have is enough."
Birke suggests that after seeing the dangers of trying to maximize in the market, more of us will become satisficers, content when we have enough. On the investment side, this would translate to a level of risk that declines over time. "As people get closer to their goals," he says, "advisors should ensure that they take less and less risk."
However, simply combining capacity and goals can result in more risk than the client is able to handle. That's where Birke's third factor comes in: style.
"The capacity and the goals give you a finite, concrete answer about whether they can have what they think they want," he explains. "The style tells you what you need to do about it." Specifically, if the client can't tolerate the amount of risk required to meet their goals, you may need to have conversations with them about adjusting their goals. Clients who are too conservative need to be educated that they have only traded investment risk for inflation risk.
It makes all kinds of sense to distinguish risk capacity (including goals) from what Birke calls "style" and Kitces splits into "attitude" and "perception." Averaging these quantitative and qualitative measures into a single risk tolerance number is bound to confuse the task of determining an appropriate level of risk, and it's one reason why so many advisors distrust questionnaires.
On Questionnaires, Some Are Agin 'Em...
Some advisors don't bother with risk tolerance questionnaires. Dick Vodra, first VP at Spire Investment Partners in McLean, Virginia, says, "I don't use a specific risk-tolerance form, because I think they are superficial and probably worse than useless. ('You won't accept a loss of more than 10%? Guess what, you just did!')" Instead, he relies on extended conversations organized around a few fundamental questions (see "Questions From an Experienced Advisor" sidebar).
Vodra encourages clients to discuss their goals, values, and experiences, their understanding of how markets work, and their expectations for the relationship. He assembles everything into an investment policy statement that the client signs (often after amending). "So far, it works pretty well," he concludes. "I've had clients change their policy—or in a couple of cases, pull their money and go to cash—after discovering they didn't want to experience as much pain as they have in the last year, but most people didn't expect me to foresee things that surprised everybody."
Bill Ramsay, an advisor with Financial Symmetry in Raleigh, North Carolina, is also no fan of risk questionnaires. "My experience is that many people's tolerance is directly correlated with recent market performance, so we shy away from questionnaires. I'm also wary of the way people can misjudge odds due to things like familiarity bias or the structure of questions."
Financial Symmetry uses capacity as the starting point for assessing risk, says Ramsay. Employing a formula that time-weights anticipated investment flows relative to assets, they arrive at a maximum equities weighting. He explains, "We then discuss with clients how that [performed] under different market conditions, and look for their wince point to gauge whether their tolerance is lower than their capacity. If their tolerance is lower, we'll lower the max equity exposure." ("Wince point": what a great term!) Like Kitces, Ramsay stresses the importance of defining a risk tolerance line that shouldn't be crossed.
...Some Are For 'Em...
Calling himself a "huge proponent" of using a good risk assessment questionnaire, Kitces warns that advisors who ask their own questions may not be consistent from client to client or may phrase questions in a way that stacks the deck toward a particular answer. While supporting the advisor's role as a trusted educator and mentor who helps clients achieve their goals (or modify goals to make them achievable), he believes some standardization of the process is useful. His preferred instrument is currently FinaMetrica's risk profile.
Sally Jo Button, a principal of Button Financial in Denver, is another enthusiast. "For years, I have been concerned that the financial industry has developed risk tolerance questionnaires based on compliance with 'Know your client' or for marketing purposes," she says. "It is the social sciences that understand how to measure human attitudes and behaviors. I was pleased to learn first of behavioral finance and then what FinaMetrica is doing."
In the August 2009 issue of IA, FinaMetrica co-founder Geoff Davey said he considers his company's "risk tolerance assessment tool" to be far superior to the standard risk questionnaire, which he calls "a jumble of questions about time horizon, goals, investment experience, risk capacity, and risk tolerance" with "all the robustness of a tabloid quiz." FinaMetrica characterizes its risk profiling process as "the financial services equivalent of the first blood pressure machine. While an accurate blood pressure reading does not, by itself, determine a diagnosis or treatment, it does provide critically important information."
FinaMetrica "is likely tops" in current risk tolerance questionnaires, says Colin Drake, a planner with Salient-Friedman Wealth Management in Novato, California. After using the FinaMetrica questionnaire for several years, Drake finds it to be a helpful tool in assessing risk tolerance. "We take it with a grain of salt, in that it plays into our portfolio recommendations but is not the basis for them," he says. Other factors such as understanding client needs, personality and preferences, building capital needs models, and considering past investment experience are also important.
Drake notes, "As expected, most clients fall in the middle range of the bell curve of risk tolerance. But we often have spouses whose scores are significantly different, and having the report is useful in opening a conversation about how best to meet both their needs.
"We avoid questionnaires to the greatest extent we can, but have decided that we and clients get value from this one," he concludes. "You can still have all the conversations with the client that you want and need, but from a compliance standpoint, it's good to have this test as one more reference point in the conversation."
...And Some Need More Convincing
Holly Hunter, a Kinder Group advisor in Portsmouth, New Hampshire, used the FinaMetrica questionnaire in 2007 "to help prepare clients for the downturn I felt was inevitable. I was able to get most to a 60/40 balanced portfolio." However, Hunter is skeptical of the questionnaire's accuracy. "I don't believe [it] was any indication of how clients would actually react when confronted with possibly losing all of their assets," she says. She feels it will be of limited usefulness in the future "except to thwart legal action aimed at the advisor."
Rick Kahler, president of Kahler Financial Group in Rapid City, South Dakota, comments that despite the necessity of risk tolerance questionnaires for legal purposes, he, too, has found them of limited value. "I decided to send out new questionnaires to my client base the third week of February 2009," he says. "Of course, I had no idea that during the time they would be answering those questions, we would be experiencing the bottom of a steep market crash."
Predictably, 50% of his clients responded more conservatively than they had to the previous questionnaire. "After I called all of these clients," Kahler reports, "half of them decided to stay put, while the other half went ahead and lightened up on equities." Those who stayed the course are up 10% to 20% this year, while those who lightened up on equities are seeing -5% to +5% returns. He adds, "Many of the clients who lightened up are now calling me wondering if they can do a new risk tolerance questionnaire, since they've decided they answered the previous one too conservatively!"
In examining FinaMetrica as a possible tool for his financial advisor clients, advisor Birke was initially very excited about the idea of a psychometric-based risk tolerance questionnaire: "The need for something like this in the marketplace is huge."
So far, however, he's unconvinced. After reading a number of studies about risk in psychology, behavioral economics, finance, and even airplane piloting, he says, "Over and over, the one consistent finding is that risk tolerance in one domain of a person's life has little or nothing to do with their risk tolerance in another domain. Whether a person speeds up or slows down when merging with another car has no statistical relevance to whether they will be financially aggressive or conservative. In the end, people's style often differs significantly from their decisions when it comes to money." Aside from that, he does believe that "FinaMetrica, or any other structured dialogue, helps couples come to understand their partners better—and that is valuable in its own right."
Getting a 360? View of Risk
After answering the 25-question FinaMetrica assessment myself, I found it a useful way to relate my risk attitude to a representative sample of the adult population. (My score showed that I'm slightly less risk-tolerant than average.) To some extent, the questionnaire also touches on what Kitces characterizes as risk perception, e.g., asking about expected relative rates of return on investments.
However, by identifying how you may differ from the average (and from your preconceptions about yourself), I think it can be a good springboard for discussions about risk with one's investment advisor. When my husband answered the questionnaire, his results were different enough from mine to raise some interesting issues about the appropriate risk level for our joint finances.
Before accepting or rejecting any particular questionnaire out of hand, try to determine what it really focuses on: the client's risk capacity, underlying risk attitude (an indication of their money personality), or perceptions of current market risk.
There may well be other questionnaires that measure the psychometrics of risk well, although FinaMetrica came up most often in my research with advisors. It seems to me that a good questionnaire can be a valuable complement to an in-depth discussion of goals, dreams, and perceptions—plus, of course, your skilled evaluation of how much risk the client can afford to take.
Since markets will continue to rise and fall, we all need to remember that risk tolerance is more than a point on a graph. As Steve Lohr said in the September 13 New York Times ("Wall Street's Math Wizards Forgot a Few Variables") about pre-crash mathematical models of risk: "The risk models proved myopic... because they were too simple-minded. They focused mainly on figures like the expected returns and the default risk of financial instruments. What they didn't sufficiently take into account was human behavior, specifically the potential for widespread panic. When lots of investors got too scared to buy or sell, markets seized up and the models failed."
In times of upheaval, it's crucial to discuss your clients' risk tolerance along with their goals, dreams, and fears in order to keep the advisor/client relationship strong. Revisit those goals and lifestyle choices periodically so the plans you develop together will keep pace with current economic reality. Then, the process of assessing and managing risk won't seem like an indecipherable mystery but rather as something you do thoughtfully and methodically, and do well.