Add historical context to risk profile questionnaires

The questionnaires lack vital context, and the allocations clients are slotted into don't mean what they once did

Few people buy cars without taking a test drive. You could tell the dealer you want leather seats, plenty of legroom and good acceleration, but without seeing or experiencing those things yourself, it’s hard to put pen to paper and sign a contract.

Yet investors are asked to make even more significant commitments without taking a test drive all the time. And advisers, whose job it is to help clients make sound financial decisions, sometimes serve as an enabling partner. Risk profile questionnaires are the culprit.

While it’s hard to believe that such a simplistic approach has lingered for so long, many advisers continue to leverage risk profile questionnaires to help with portfolio construction as a result of compliance considerations. Many of you have likely been there: A client responds to 10 general questions, and boom — you slot them into an allocation that best fits their profile based on their answers, whether that’s 60/40, 80/20 or another.

One big problem is that risk profile questionnaires lack vital context. A common question asks clients what they would do if a fund dropped 10% — buy, hold or sell? Because market moves don’t happen in a vacuum, that’s impossible for anyone to answer without more background. What caused the drop? Was it market-related or specific to the investment? Did the reason for owning that investment change?

The second — and more significant — issue is that those allocations don’t mean what they once did. A recent Bank of America research note alluded to this, saying that because lingering low interest rates will continue to haunt bonds, price fluctuations in those instruments could present future problems. Based on this, bank analysts concluded that a massive class of risk-averse investors should now reconsider whether a 60/40 portfolio was a good fit.

To that I say: What took you guys so long? Rates have been plunging not for a couple of years but for well over a decade. What’s more, the notion that 60/40 portfolios are only now beginning to enter a period of uncertainty is nonsense.

According to our research, for every one-year interval since the beginning of 2000 (Note: Not each year — each one-year interval, meaning a new one begins each day), such allocations endured losses more than a third of the time. Meanwhile, they have dipped 13% of the time during all the three-year intervals over the same period.

Therein lies the problem: For far too long, our industry has presented solutions — fixed allocation strategies — that presume risk is static, even as we know from history that market performance, and thus risk, are dynamic.

Over the last 20 years, we’ve had spells when stocks have plunged or struggled to tread water. And then there were other times when they seemed to go up every day. As demonstrated above, whether a 60/40 allocation is “safe” would have been highly variable during any of these times.

History is important. While we all know that past performance doesn’t mean jack in predicting the near-term future, appreciating a range of results for various allocations can help us develop a more robust expectation for potential future outcomes.

Yes, history may be only a guide, but it’s the only guide we have, and it’s how advisers should test-drive the investment decisions they make for clients.

[More: New 60/40 portfolio substitutes riskier hedges for U.S. debt ]

Greg Luken is founder and CEO of Luken Investment Analytics, subadvisor for the Smart Diversification Fund and provider of the Allocation Test Drive.

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