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In the early days of financial planning, advisers would assess a client’s attitude about risk. It was largely a subjective judgment. Nevertheless, their conclusion (or hunch) would guide their portfolio management decisions on behalf of that client.
In addition to probing to determine a client’s tolerance for risk, advisers might consider one’s age, gender and investment experience before assigning labels such as, say, “highly conservative” or “moderately aggressive.”
Nowadays, evaluating a client’s risk tolerance is a big part of an adviser’s job. Aside from matching investment recommendations to fit a client’s preferences, advisers must show industry regulators that they are fulfilling their fiduciary duty to serve a client’s best interests.
If an adviser were to hype high-risk investment products to a risk-averse client who prioritizes wealth preservation, for example, it could create compliance headaches. And disgruntled clients might quit and find another adviser.
Over the past decade, many vendors have launched tech platforms to help advisers identify a client’s risk tolerance. Surveys are popular: For many advisers, part of the onboarding process involves administering a questionnaire to new clients about their risk/reward calculus.
Some longstanding risk-tolerance measures include Riskalyze, which assigns a “risk number” to each client, and FinaMetrica. Some advisers rave about these tools. They stick with these risk profiles through thick and thin and use them to guide their advice amid market swings.
Jamie Lima, a certified financial planner in Ramona, Calif., uses DataPoints to get a better sense of clients’ financial personality. He likes how its focus on psychology helps uncover one’s money mindset. “It’s more behavioral finance, not ‘Rate this on a 1-to-10 scale,’” he said. “Its questions are more EQ [emotional quotient], not IQ [intelligence quotient].”
Others are more skeptical of these tools. They may have concerns about the survey design, the nature of the questions or their overall effectiveness in accurately predicting how an investor will react to risky bets.
“I used a risk-tolerance questionnaire for about a year,” said Noah Damsky, a Los Angeles-based adviser. “It was so imprecise. How a client views risk can change from today, tomorrow and 10 minutes from now. That’s because it’s an emotional response, and emotions can change.”
Damsky also found that clients disliked completing the surveys. Some found the questions confusing. For example, he recalls clients balking at questions about how much of a financial hit they would accept to their portfolio. Mystified clients would ask Damsky, “Why would I be willing to lose 10%, or 20%, or whatever percent?”
Moreover, he rejects the argument that administering these surveys from year to year enables advisers to track changes in one’s risk tolerance. “It’s like when you get your annual physical and you have to fill out all those [patient] forms all over again,” Damsky said. “It feels like a formality that really feels like a waste of time.”
Through the regular financial planning process, Damsky gains sufficient insight into each client’s risk tolerance — without the need for surveys, digital platforms or other supplemental tools. If clients are strongly adverse to debt, for instance, he finds that they tend to be risk-adverse in general.
Like Damsky, Zachary Scott has reservations about relying on risk-tolerance tools. “Clients’ attitude toward risk definitely changes with different market conditions,” said Scott, a certified financial planner in Catonsville, Md. “But risk-tolerance questionnaires are very static.”
When meeting new clients, Scott examines their portfolio for clues about their risk level. One opening question: “Why are you invested in the way that you’re invested?” Says Scott: “Understanding their goals and finding out what they’ve done in the past gives me a far better understanding of their risk tolerance.”
Also read: Cash is no longer trash, says Ray Dalio, who calls it more attractive than stocks and bonds
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