Advisers must align a client's portfolio with these 3 personal risk measures

Michael Kitces warns that unless risk tolerance, risk capacity and risk perception are considered, investment losses can drive clients away from markets forever.
MAY 02, 2018

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. (More: Is technology helping advisers assess risk?) 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. (More: Low returns create bleak outlook for clients in 'retirement red zone') 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.

Latest News

Trump loses patience as SALT block stymies GOP tax bill
Trump loses patience as SALT block stymies GOP tax bill

The president urged Republicans repping high-tax states including New York to accept a $30,000 deduction cap for now, but the holdouts remain dug in.

'Disgruntled' ex-Wells Fargo advisor loses fight with firm over loan money
'Disgruntled' ex-Wells Fargo advisor loses fight with firm over loan money

An effort by the advisor to move to the bank's independent contractor division proved to be a critical detail to the dispute.

Ex-Osaic advisor fined over failure to declare $1M bequest
Ex-Osaic advisor fined over failure to declare $1M bequest

The New York-based advisor, formerly affiliated with Securities America, has also been suspended for failing to disclose his status as a beneficiary.

Are advisors missing retirees' needs in 'fragile decade'?
Are advisors missing retirees' needs in 'fragile decade'?

Survey suggests financial professionals are falling behind investors' need for guaranteed income and asset protection in their golden years.

RIA acquirer Bluespring welcomes Georgia-based Clarivise Private Wealth
RIA acquirer Bluespring welcomes Georgia-based Clarivise Private Wealth

The Alpharetta-based advisor ensemble enters a new chapter in its partnership with the Kestra Financial subsidiary.

SPONSORED Beyond the dashboard: Making wealth tech human

How intelliflo aims to solve advisors' top tech headaches—without sacrificing the personal touch clients crave

SPONSORED The evolution of private credit

From direct lending to asset-based finance to commercial real estate debt.