Determining a client's ability to handle risk can be a daunting challenge.
The questionnaires financial planners use to assess risk tolerance are typically one-dimensional, focusing almost completely on a person's capacity to absorb a loss without it affecting his or her lifestyle.
The dangers of stereotyping
Those questionnaires -- and the advisers who use them -- tend to make assumptions based on age, goals and how much money a client has to invest. And that's a great starting point. But it also can make everyone within a certain demographic look similar.
It presumes, for example, that all 30-year-olds have the ability to take substantial risk because, well, they're 30; if the market crashes, they'll have plenty of time to make up their losses. Similarly, it surmises that every 60-year-old is determined to retire ASAP, and must invest accordingly.
Unfortunately, this way of looking at people's wants and needs frequently misses the mark. I tell clients it's like getting in line to ride the merry-go-round and finding out, just as you reach the front, that you're about to board the most formidable roller coaster at the park. Likewise, if you're in line to get on the killer coaster, you don't want to end up on the merry-go-round -- it will bore you to tears.
New tools go deeper
The good news is there are some new profiling tools that do a much more comprehensive job testing an investor's true tolerance for risk using the principles of behavioral finance as well as those more traditional demographic categories.
Riskalyze starts with an online test, so you can do it at home, but we think we get better results if we administer it in person. We ask several questions related to financial risk, and the person is assigned a risk number based on his or her answers. Then we use that number to build a better portfolio and a financial plan that takes into account the capacity for risk, but also internal, emotional tolerance.
Diagnosing one woman's case of nerves
A good example is a woman who came in, a prospective client at the time: She wanted to retire, but she was nervous because she wasn't sure she had enough money. She had plenty -- by anyone's definition she had enough to retire comfortably.
But the reason she was anxious -- and she didn't realize this -- was that her portfolio was so exposed to volatility.
We took the test with her, and her score came in at 27, which means she has a very low tolerance for risk. But when we plugged her portfolio into the system as it was currently managed, it came out as a 77. She was 50 points off -- the ultimate case of somebody who thinks she's on the merry-go-round but is actually white-knuckling it on the roller coaster. She knew it deep down inside -- it's why she was so apprehensive about retiring -- but there was no way for her to describe it.
We made it our goal to move her closer to 27, where she'd feel less stressed, and it helped solve that "am I prepared?" dilemma for her. She contacted us recently and said she's ready to retire.
More meaningful results, conversations
With older assessment tools, it's easy for financial professionals to be subjective -- to let their perspective, or experiences with different clients, taint what they do. This woman's former adviser probably thought he was building a smart, solid and -- by his definition -- conservative portfolio. It just wasn't right for her.
Using this new technology can make the conversations we have with clients and future clients much more meaningful.
Once we've got that number, we can measure it against how much money someone has, how much is invested, if it's growing and at what rate, a desired retirement date, income needs, inflation, etc., and we can say, "You want this risk number, but we're concerned, because for you to have success, that risk needs to be higher." Or on the flipside, "You have this tolerance for risk, but you definitely don't have to take it that far to accomplish your goals."
The program's mapping module lets us project with 95% accuracy whether a portfolio will achieve the returns the client desires. That's a comforting thought both for the client and the adviser -- especially if you're acting as a fiduciary.
Now we can say the plan we built is right where the client told us it needed to be.
Kim Franke-Folstad contributed to this article.
Investment advisory services offered through Hobart Private Capital, LLC. Securities offered through GF Investment Services, LLC. Member FINRA/SIPC.
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