Do Advisors Get Clients' Risk Tolerances Wrong If They Only Use Questionnaires?

Monday, March 21, 2011 07:02
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Do Advisors Get Clients' Risk Tolerances Wrong If They Only Use Questionnaires?

Tags: client communications

The risk questionnaire is a standard part of every new client interview, but does it work? An Australian company claims it's got a better way to determine just how much risk your clients can take.

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FinAmetrica co-founder Geoff Davey points to academics who looked at a lot of risk questionnaires and found that "risk-averse" clients still ended up with 0% to 70% stock allocations while "aggressive" ones ended up with 50% to 100% in stock. 

 

That's an incredibly wide range -- reminiscent of the allocations used by target date funds -- and reflects what Davey says is the unscientific nature of the old-fashioned survey. 

 

While we can't yet gauge his claim to have come up with a better mousetrap, the sheer overlap between what investors say are their risk tolerances and the investments advisors put them in is truly stunning.

 

In theory, a very conservative and a very aggressive investor could both be put in the exact same portfolio -- 70% stock, 30% fixed income.

 

That's not only dangerous for the risk-averse client, but potentially a fairly serious breach of the suitability standard. But in a world where traditionally risk-averse retirees are increasingly invested in stocks "for appreciation over the long term," it's easy to see where it comes from.

 

The question is whether we all need to reassess what we mean by risk and how we manage it in the post-recession world. 

 

Comments (4)

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mels941
Risk is a multidimensional trait. The Moneymax Profile looks at 13 traits to determine the risk profile of a client. See www.financialpsychology.com for more info
mels941 , March 21, 2011
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johnd508
There is a simple method to determine risk tolerance that involves the client and requires their buy-in - painlessly but certainly.

Create a number of scenarios by combining your favorite market indices in weighted mixes to equate to a range of strategies. Create a return time series for each mix. Calculate total returns and draw down returns for each series, including of course, the maximum draw down return (MDDR.) Show the client the results graphically and in tabular form. Ask the question "what strategy would you have felt comfortable with given these choices?" Once the selection is made you know two things for sure, their risk tolerance expressed as, say the standard deviation of the strategy's time series and the mix itself. Your experience will tell you how many prospective strategies to present to the client and their array of information ratios. I think that a dozen ought to do it, though you may have to have special sets for younger and older clients (think Ron Surz's glide path.) JFD
johnd508 , March 21, 2011
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vguettlein
The problem with Fina Metrica is that clients are asked to determine how much they want to beat average cd rates by - without any indication of what "average" is. I have clients that think they should be getting 2.5-3% above because cd rates are paltry. Fina Metrica will not publish what "average" is, so we're left to come up with our own "average". And apparently only those in Category 3 or below have any real likelihood of not being disappointed with their results. I think they have some great research, but frankly I've not found them to be terribly user friendly. Maybe I'm just dumb and don't get it. Maybe my clients are even dumber - they don't get it either. The best question on that questionnaire is the one about max drawdown. While I think "a dozen or so" is too much, I think JohnD508's suggestion is a good one.
vguettlein , March 21, 2011
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ScottMartin
Hi gang -- thanks for weighing in.

Love the scenarios-based approach. For one thing, it's a great way to demonstrate the value of a Monte Carlo-style approach without forcing the client to appreciate the jargon and technology for their own sake -- a real obstacle. And the psychologists always tell me that any time you can turn abstract information into a story, people react to it more honestly. (Of course, any time the great Ron Surz is in the picture, I'm biased.)

Agreed about the problem of "average." I've been grappling with the problem of how advisors manage expectations in the new environment and it sounds like Fin Metrica just doesn't get it. Sure, I want an above-average rate. All our kids are "above average" and so on. But that's not a good way to manage expectations or even find out how much risk a client can handle.

Either way, if the clients don't get it, it's not the right solution!
ScottMartin , March 24, 2011

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