What can happen if an adviser doesn't properly align a client's investment portfolio with their risk tolerance?
They could lose clients or even face a lawsuit, said Michael Kitces, partner and director of research at Pinnacle Advisory Group. More importantly, too much unwanted risk can scar investors so badly they are forever pushed away from participating in markets.
"They sell and they never come back ," Mr. Kitces said during a keynote at
InvestmentNews'
Retirement Income Summit in Chicago on Tuesday. "That's what happened to the lost generation in the 1920s."
Mr. Kitces said his own grandfather never bought a stock again after losing everything in the 1929 market crash. With many advisers still relying on deeply flawed methods to assess risk tolerance, he worries the industry could once again be setting up an entire generation to avoid investing.
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The problem is too many risk questionnaires do not distinguish between an investor's attitude about risk and their financial capacity to take on risk, he said.
Risk capacity determines how much risk a client can afford to take or needs to take to achieve financial goals. Risk attitude (or tolerance) establishes the upper limit on the amount of acceptable risk.
"Both of these dimensions matter, and both can be constraints," Mr. Kitces said. "If you want to be aggressive, you have to check the box for both tolerance for risk and capacity for risk.
"The fact that you can afford to take risk doesn't mean you should if you can't tolerate it," he said.
Then there is a third dimension: perception of risk, which is how the client evaluates whether the implemented portfolio is consistent with their risk attitude.
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Risk perception is tricky because it can be distorted by a number of natural mental biases, Mr. Kitces said. Someone on a winning streak thinks they are going to keep winning, while a single loss can lead investors to become bearish.
"Some clients are terrible about maintaining their composure," Mr. Kitces said. "Their actual tolerance doesn't change, but their perception of how much risk they are taking swings like a metronome from one extreme to the other."
It's the adviser's job to constantly manage those perceptions and align them with the portfolio the adviser has constructed.
But advisers also must be mindful of their own investing biases. Advisers tend to be much more tolerant of risk than average investors, Mr. Kitces said, and shouldn't try to drag clients out of their comfort zone.
"It's an important thing to watch out for," Mr. Kitces said. "We have have a tendency to impose our comfort and our risk tolerance on our clients."
He recommended advisers use a risk questionnaire that has been created using psychometrics — the science of measuring mental capacities and processes.
By blending a scientifically crafted questionnaire with a personal conversation during the financial planning process, Mr. Kitces said advisers can better understand the client's true risk profile and ultimately deliver better outcomes for the client and the firm.
