Measuring client risk tolerance
Advisers often mistakenly equate risk tolerance with risk behaviour and interpret changed risk behaviour as changed risk tolerance.
Just because someone’s behaviour has changed doesn’t mean their risk tolerance has changed. Behaviour in risky situations will not be a function of risk tolerance alone.
Goals, the perceived risk, the perceived alternatives and the level of trust in an adviser all will play a part.
We also know that risk tolerance is stable, even through a bear market (various studies confirm this). When behaviour changed in the recent bear market, it was much more likely to be because perceptions of risk had changed.
Clients (and many advisers) simply had no idea that what did happen could happen. Perceptions of risk can change in an instant.
Questioning advisers who say their client’s risk tolerance has changed usually leads to their agreeing that this view is an assumption based on observed behavioural change.
Educating clients
A similar argument can be made regarding education. After education, clients may be willing to do things that beforehand they would have rejected as too risky.
However, this doesn’t necessarily mean their risk tolerance has increased, it could be that their perception of the risk has decreased. In fact, I think that’s a far more likely explanation.
My reasoning has a number of bases:
it is generally difficult to change a psychological trait through education;
while financial planners are more risk tolerant than clients, there is a not insignificant proportion of financial planners who despite their education have very low risk tolerance (two standard deviations below the client mean); and
the only education-affects study on this issue indicates no change in risk tolerance.
We know that financial planning students are more risk tolerant than clients, and financial planners are more risk tolerant that financial planning students.
Some would interpret this as risk tolerance increasing through education. My guess is that it’s primarily due to selection — financial planning students start out more risk tolerant, and the more risk tolerant of those go on to be planners — but time will tell.
Think about it. Which seems more likely: that through education you can increase someone’s appetite for risk, or you can decrease the perceived level of risk in a particular course of action with which they were previously unfamiliar?
Re-assessing risk tolerance
Though a financial plan may have a 50-year time horizon, it will probably have a half-life of only a few years.
A major review/redo of a plan should involve a re-assessment of all the ‘soft’ criteria.
Even if a plan has not changed, risk tolerance should be re-assessed after any significant life event (positive or negative) and otherwise every two or three years.
While there’s no specific formal evidence that risk tolerance can be changed by life events, we know that other traits can be, and so it seems sensible to assume that risk tolerance can be — and there is no downside to reassessing it.
Additionally, there is pretty convincing evidence that risk tolerance decreases with age, so periodic retesting is advisable.
Why is it that the vast majority of planners only ever talk about risk tolerance in an investment context? Are they financial planners or investment advisers?
Trust in the adviser
Imagine you are a somewhat nervous passenger being driven at what seems like breakneck speed by a lifelong friend you trust completely, who also happens to be a world champion rally driver, and then she starts going much faster. Think about this scenario for a minute.
We’ve all been passengers in cars that were being driven too fast and also in cars that were being driven too slow.
Generally, we each have our own comfort zone between what’s too slow for us and what’s too fast.
We will be willing to stretch that comfort zone under the right circumstances and, if we really trust the driver, maybe by quite a bit, but only so far.
My experience is that advisers who bring up the trust issue tend to think of financial planning as something that is done to clients rather than with clients. They have strong views as to what’s best and see any adjustment to their best solution to accommodate their client’s risk tolerance as compromising good advice.
They are often very experienced with strong investment knowledge and skills, and sometimes quite high public profiles.
If a client is not willing to accept the level of risk the adviser recommends, the adviser sees that as a shortcoming in the client, something to be fixed by education.
Determining the ‘right’ risk level
Imagine two such advisers — one, A, with risk tolerance one standard deviation greater than the average client and the other, B, with risk tolerance two standard deviations greater than the average client.
Each would have a view as to the right amount of risk for clients to take, but they would almost certainly be different amounts, with B’s greater than A’s.
Both would say that clients typically weren’t willing to take enough risk and had to be educated to ‘fix the problem’.
Both would be opposed to their clients taking less than the ‘right’ amount of risk.
However, they wouldn’t actually agree on how much risk was ‘right’, though they would agree that the client’s risk tolerance shouldn’t be a factor.
Some advisers see any decision by the client to take less risk than what is being suggested as a challenge to their authority.
Additionally, the time and effort involved in assessing risk tolerance and then having regard to it in the advising process is seen as an unnecessary cost and complication in a production process.
In this context, why do such advisers want their clients to trust them absolutely? So that the client will accept a level of risk (significantly) greater than they would otherwise choose.
Achieving financial goals
It is common, particularly with new clients, for the adviser to be in a position of having to tell the client that their goals don’t appear to be achievable from the resources available at the level of risk the client would prefer to take.
Such a mismatch can be resolved by some combination of taking more risk, easing goals or applying more resources.
The adviser’s role is to suggest and illustrate alternatives, but the decision must be the client’s.
Too often, though, an adviser will simply see this situation as a risk tolerance problem because the goals would appear to be achievable from the available resources at the level of risk the adviser would be willing to accept.
An adviser who doesn’t explore all alternatives with their client is simply not acting as a fiduciary and, because they do not have the client’s properly informed consent, will be legally responsible for any loss their client might suffer.
That having been said, there’s nothing wrong with a client taking more risk than they would prefer (because their goals are really important), provided it is done knowingly and the alternatives have been considered.
Practical issues
So far, I’ve been talking about value issues.
Let’s look at practical considerations.
What is an adviser to do with a new client? Wouldn’t the adviser want/have to know the client’s risk tolerance?
If there’s a big gap between what the client is comfortable with and what the adviser would recommend, doesn’t the adviser need to know this?
Shouldn’t this be discussed with the client?
Now let’s consider an established client (with a high level of trust in the adviser) whose goals appear unachievable from resources available at the preferred risk level.
Does the adviser have the type of alternatives/ trade-off discussion outlined above? If not, why not?
If that discussion doesn’t resolve the problem, then the only circumstance where a trust-based solution would work is where the client has no knowledge of the level of risk they will be taking — that is, risk is not discussed at all, hardly a path to be encouraged.
As we move through what several commentators view as the final stages of the boom market in both property and shares, how well we manage client’s future expectations will be critical.
An understanding of a client’s risk tolerance may prove useful as we manage their inevitable disappointments.
Geoff Davey is co-founder and chief executive officer of Finametrica.
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