Keep clients for the long haul by bolstering risk assessment procedures

Let’s start with the good news.
Nowadays, there’s little debate over the merits of measuring risk tolerance. Legislative and regulatory trends have evolved since the financial crisis to require that financial advisers, brokers and consultants know more about their clients. According to Finra Rule 2111, investment firms are obligated to assess risk tolerance and incorporate those findings into a client’s investment strategy.
This is good progress. More and more, advisers across the country are demonstrating greater risk assessment capabilities, ranging from paper questionnaires to systems backed by quantitative analytics. You’d be hard-pressed to find a practice in today’s landscape that doesn’t, in some manner, examine a client’s risk tolerance level.
While we’re moving in the right direction, there’s still work to be done. For practices looking to bolster their risk assessment procedures, here are a few key issues to consider.
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What Is Risk Tolerance?
There are still misconceptions out there about what “risk tolerance” actually means. Finra’s definition of risk tolerance — “a customer’s willingness to risk losing some or all of the original investment in exchange for greater potential returns,” according to its website — gets the central gist. But it does not do enough to clarify how it differentiates from other components of risk, which are often conflated.
FinaMetrica’s data, pooled from over 800,000 risk tolerance tests administered since 1998, suggests that risk tolerance is a psychological trait that, barring any major life events (such as a dramatic loss of wealth or divorce), does not change dramatically over time. As people age, their risk tolerance may decrease slightly. Generally speaking, however, a person’s risk tolerance is stable throughout adulthood.
It is therefore important to differentiate “risk tolerance” from two other risk-related concepts: risk required, the amount of risk needed to reach one’s investment goals; and risk capacity, the amount of risk one can afford to take without derailing short- and long-term financial viability. By distinguishing between these concepts, financial professionals can gain a better understanding of who their clients truly are and devise an assessment protocol that yields useful results, even if a client’s “risk tolerance” and “risk required” point in opposite directions.
How Should Risk Tolerance Be Assessed?
Regulation does not address how financial professionals should measure clients’ risk tolerance. Here are a couple of key suggestions to keep in mind when considering your own risk assessment protocol.
First, given that many firms have developed their own questionnaires or other related methodologies, financial professionals may not be accounting for a serious bias, namely that financial professionals themselves tend to possess a higher risk tolerance than their more conservative clients. As a result, advisers may unintentionally skew their clients toward a risk level that lies beyond their comfort zone.
The fact is, clients think and respond emotionally, and advisers need to meet their expectations accordingly. Well-intentioned advisers focusing on the long-term need to prepare their clients for the journey. Doing the right thing financially is vital, but so is meeting clients’ emotional needs.
Setting proper expectations at the start of a relationship is one way to minimize the consequences of these pitfalls. Having an objective, third-party testing system — preferably one with scientific and statistical backing — can help control latent biases towards risk as well.
Second, financial professionals must ensure they understand differences in the risk tolerance levels between partners and other family members. As an example, FinaMetrica’s data shows that 67% of U.S. couples have a material difference — meaning one standard deviation or more — in their levels of risk tolerance. In 83% of those cases (when we’re dealing with heterosexual couples), the male partner is the greater risk taker.
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Regardless of how these demographic and sociocultural trends evolve over time, financial professionals must have adequate tools to compare partners’ risk tolerance levels and adapt these findings to an investment strategy that meets their emotional and financial needs. It’s critical that all decision-makers have a voice, even if one partner plays a larger role in financial matters.
A Matter of Survival
Why is this so important? Inevitably, bear markets will come just as bull markets do. In addition to the obvious ethical responsibilities to which advisers are beholden, there’s a practical motivator at play. Firms without the requisite client risk assessment system will have greater difficulty keeping business when bad times arrive. Financial professionals must have the proper due diligence systems in place to make sure the client stays for the long haul.
That’s why, when risk tolerance is assessed properly, everyone — the client and the adviser — wins.
Paul Resnik is the co-founder and co-director of FinaMetrica, a specialist in risk tolerance and risk-related matters.