ADVISERS TAKE RETURNS, LET RISK RUN, BEHAVIORAL FINANCE STUDY SHOWS: MICROSCOPE TURNED AROUND TO VIEW PROS RATHER THAN CUSTOMERS

Forget about clients: Advisers may want to spend more time assessing their own risk biases.

According to an in-depth survey of 265 advisers and financial planners nationwide, these professionals put more weight on an investment’s potential returns than its risks when assessing its quality.

The study is one of the first to apply behavioral-finance principles to advisers, many of whom have taken increased interest in the subject as it pertains to their customers affecting the market. With this project, the attitudes of advisers — not those of investors — are under the microscope.

Still a working paper, the study is expected eventually to be published in the Journal of Financial Planning. It was financed by Milwaukee-based Heartland Funds and the National Science Foundation.

While few would argue that risk is as important as potential return when assessing a specific security, advisers are giving risk short shrift and focusing mostly on returns, says one of the study’s authors, Donald G. MacGregor, senior research associate at Decision Science Research Institute in Eugene, Ore.

“The goodness (of an investment) is largely defined in terms of return,” he says. “Basically, risk comes into it only at the extremes.”

While that’s not surprising, says another co-author, Harold Evensky of Coral Gables, Fla., planning firm Evensky Brown Katz & Levitt, the work shows that assessing risk is more complicated than determining an asset class’s historical price volatility.

risk in the sixth dimension

“What it clearly pointed out is the multiple aspects of risk,” he says. “All too many of us tend to focus on the unidimensional notion of risk. But intuitively we use a multidimensional measure.”

For instance, advisers perceive risk for some asset classes based on the frequent performance monitoring they believe they’ll have to do. In other words, they think they’ll have to spend more time bird-dogging a small-cap stock than a blue-chip growth stock.

“We’ve wanted to use commodities for a long time, but we haven’t, largely because of the hassle factor,” Mr. Evensky says by way of example.

For other asset classes — bonds, in particular — advisers cite inadequacy of regulation as a risk.

In the survey, the asset classes advisers identified as having the best return-to-risk profiles were blue-chip stocks, small-cap stocks, mutual funds, foreign stocks and commercial real estate. The worst were gold, Social Security, life insurance, U.S. savings bonds and initial public offerings.

Interestingly, advisers placed IPOs behind only small-caps in offering the potentially highest returns, but also labeled them the riskiest of the 19 asset classes on which they were surveyed.

Mr. MacGregor, who’s slated to address the subject of risk this June at Undiscovered Managers Funds’ behavioral finance conference in Chicago, says the results point to the need for advisers to assess their own risk views and communicate them to clients.

“Many advisers are reluctant to bring their own views on risk into the relationship,” he says.

more art than science?

Instead, he says, they spend most of their time trying to gauge their clients’ risk tolerances and then input a number into an “optimizer” computer program to derive an appropriate mix of stocks, bonds and cash. There’s more art than science to investment advice, however, he says.

“The relationship is more like a counseling relationship than a build-me-a-house relationship,” he says. “Those kinds of software programs need to be taken with a large grain of salt, and most advisers know that. But you can still over-rely on them.”

“There is overreliance,” agrees Jim Azzarello, whose Rolling Meadows, Ill., firm, Robert James Financial Group Inc., is affiliated with LPL Financial Services.

“Is anybody really saying to the client, ‘Here’s where I come in on this?’ “