Stereotypes in risk mean misaligned portfolios

Adviser assumptions don't always match a client's risk preference; there are consequences

Apr 20, 2015 @ 12:45 pm

By Alessandra Malito

Financial advisers should check their assumptions at the door when it comes to determining a client's appetite for risk.

Basing decisions about a client's risk characteristics on such factors as age or gender often lead to poor results and unhappy clients.

"If you assume based on age, you may end up with a plan that's good for goals, but not one that they'll stick with, and that's just as important," John Ndege, founder and chief executive of PocketRisk, a company that works with advisers to assess clients' risk tolerance.

Dealing with risk and the millennial

One stereotype that advisers tend to play into is the assumption that younger clients are more comfortable with risk. As a result, millennials' portfolios tend be overweight equities — based on the erroneous notion that they are more likely to stay put in a correction.

In fact, target date fund recommendations designed specifically for millennials exceed the risk profile of 96% of their intended audience, said Tyler Nunnally, a U.S. strategist for FinaMetrica, another company that works with advisers in assessing clients' risk tolerance.

That's because millennials are actually quite averse to risk. Having lived through two economic downturns, and several major market corrections, millennials are conservative investors — much to the surprise of many financial advisers.

"With the current generation, the millennials, there's a perception they should be much more aggressive in their thoughts," said Victor Ricciardi, a finance professor at Goucher College.

Failing to understand a client's risk profile may have lasting implications.

"They may want to sell at the bottom and avoid investing for several years, and miss out on an upswing in the market," Mr. Ndege said. "But if [an adviser] is cognizant of risk tolerance and put them in something not as risky but that still has a good return, [the client] is more likely to stick through the tough times."

Having the risk talk

Determining a client's ability to handle risk warrants communication between adviser and client.

Riskalyze, a technology provider that works with advisers to measure clients' tolerance for risk and then compares that with their current portfolios, found that clients portfolios don't often align with their actual risk profile.

Of investors 20-29, 52.9% were invested outside of their risk preference. Meanwhile, 53% of investors older than 70 are also invested outside their profile.

"It's a big wakeup call," said Aaron Klein, chief executive of Riskalyze. "It creates an urgency that we've got to do a better job as an industry."

Riskalyze created the "risk number," a metric that takes answers from a questionnaire sent to clients and pairs it with an appropriate portfolio. The risk number is scaled between 0 and 100, and the lower the number, the more risk averse the client.

"It forces you to have a difficult conversation with how people are invested and how they're answering questions," said Nicholas Hopwood, president at Peak Wealth Management in Plymouth, Mich. "In many cases, it will confirm where we are and facilitates discussion if any changes are needed to be made."

Using a way to measure risk and then talk about it with the client helps advisers "make sure the portfolio is lined up with their beliefs rather than our beliefs," Mr. Hopwood said.

You are not your client

Advisers need to differentiate themselves from their clients when it comes to tackling risky investments.

Mr. Nunnally said advisers tend to be more risk tolerant than their clients. That bias often creeps into clients' portfolios, he said.

"In a lot of cases [advisers] push their risk tolerance off on clients," Mr. Nunnally said.

Some advisers agree.

"In our industry, we run the risk of investing for our clients like we would invest for ourselves," Mr. Hopwood said. "We impress upon them our own beliefs of risk but that's not our job."

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