Conventional risk tolerance questionnaires fail to help advisors set client expectations”, believes William R. Nelson, Ph.D., “Setting both groups up for failure”

The Impact on Clients and Your Business

Advisors have for decades treated conventional risk tolerance questionnaires as a check box burden. Clients answer some questions, out comes a categorization from conservative to aggressive, and the client is assigned to a portfolio that contains the category name in the portfolio name, such as Example Financial Conservative.

The process was designed primarily to fulfill the “know your client” compliance requirement. Regulators were satisfied, but clients were often dissatisfied because their expectations were neither set nor met. How has a process relied upon by so many smart people for such an important job survived for so long while providing such inconsistent and often misleading advice? The industry incumbents are huge companies impeded by bureaucratic momentum, hence the sticky status quo.

I’m a former business school professor, fintech co-founder, and Chief Investment Officer who oversaw billions of dollars. In my opinion, clients expectations are not set and thus are not typically met by following the conventional risk tolerance questionnaire process and will not lead to investor and advisor success throughout market cycles.

I think the story below clearly explains how by doing something different you can succeed in setting and meeting your clients’ expectations, which builds trust, helps keep clients, and garner referrals.

Ron wasn’t happy with his investments so started researching what to do.

First, Sammy, the super smart next door neighbor, recommended visiting the American Association of individual investors (AAII).

Ron found the following asset allocation recommendations on their website.

portfolio comparison

Because Ron is 65 and retired he thought that the Conservative Investor profile matched him best.

Next step, figuring out how to implement the 50% fixed income and 50% diversified stock recommendation. Ron Googled Merrill Lynch hoping to open an account, but also found some of their asset allocation recommendations.

assest allocation ex

Ron first looked at the conservative portfolio, because that’s where he fit according to the American Association of Individual Investors. Why is Merrill Lynch (ML) recommending 20% stocks, which Ron understands are risky, when the AAII recommends 50% in stocks. That’s 2 ½ times more risky stuff. How can they both be right? What does conservative really mean? Ron decided it was time to talk to a professional.

Ron was referred to Adam, a financial advisor. After introductions, Ron asked, “Why does the American Association of Individual Investors recommend a conservative investor like me invest 50% in stocks and Merrill Lynch recommends 20% in stocks?”

Adam replied, “Good question, apparently everyone does not agree either on what it means to be conservative or the riskiness of stocks. How about we not merely assign you a category, but instead directly figure out how much you should have invested in stocks based on how much risk you are willing to accept?”

“Of course” exclaimed Ron, “Run the numbers.”

Adam brought the ‘Real Risk Meter onto his wall screen and began a conversation about the tradeoffs between risk and return and how tolerating more risk during market declines could mean more money in the future. Adam asked, “What if you lost 5%? Would you be able to continue holding your investments without losing sleep? How about 10%? OK, so you’d feel compelled to sell if you lost more than 10%. So, 10% is your Real Risk Tolerance. A portfolio with 10% risk can expect a return in the range of 4% per year. I know it doesn’t sound like a lot, but 4% can compound to 48% over 10 years. And, beware; I’d avoid anyone who tells you that you can earn double digit returns without 50% real risk. If it sounds too good to be true, it probably is.”

Adam then showed to Ronald how the US stock market fell by close to 50% in around 2001 and 2009.

“Ron, you should choose investments you can stick with through such declines, assuming your stocks also lose 50% of their value. Investors who sell during market declines tend to underperform and suffer from the stress of unwanted account value volatility.”

Adam suggested two different asset allocations with two different ways of mitigating risk. The first was an asset allocation of bonds, but with no stocks, because a typical bond portfolio like the Vanguard Total Bond Market Index Fund Investor Shares (VBMFX), has experienced falls in share price of 10%.

Numbers 2

Adding any stock to the portfolio, would increase the risk above 10%. The second alternative presented was a Hybrid Allocation of 80% fixed annuity and 20% stocks. The fixed annuity is contractually guaranteed not to lose value. If the 20% in stocks losses half their value, that equals the 10% Real Risk tolerance of Ronald. Ronald liked the idea of having some stock market exposure and didn’t require much liquidity because he has a pension and Social Security.

Ronald then asked, “How much Real Risk was Merrill Lynch’s conservative portfolio?”

Adam answered, “a little less than 15.5%, because 20% equities*50% real risk plus 55% in fixed income * 10% Real Risk equals 15.5%, assuming cash has a Real Risk of zero.

“Wow that’s over 50% more risk than I wanted to take” What about the 50/50 portfolio recommended by the American Association of Individual Investors?
“50% equities*50% real risk plus 50% in fixed income * 10% Real Risk equals 30%.”
“Adam,” How can portfolios with 10% Real Risk and 30% Real Risk both be called conservative? I couldn’t handle losing 30%”

I’m not sure, that’s why I use Real Risk that provides transparency and a positive context for discussions of risk and reward with my clients.

If you want to win new clients like Adam did, then the Real Risk Meter was invented for you!

Real Risk Meter facilitates alignment of the Real Risk™ tolerance of investors with the Real Risk of their investments. Real Risk is the percentage fall from peak to trough, just as the pundits discuss it every day on the news, which is also how I think most investors feel risk.

Use of the Risk Meter can support a constructive and educational conversation about the tradeoff between risk and return among advisors and clients. The client directly decides how much Real Risk™ should be taken rather than depending on a mysterious black box. To help investors stick with their plan, even during turbulent markets, the investment policy statement includes a Risk Pledge ™ in which clients’ current, calm selves promise their future, frantic selves not to capitulate and sell their investments so long as the agreed upon Real Risk loss percentage has not been exceeded. I believe the path to reliable advice and client satisfaction is clear.

A full featured, free, two week trial of RealRiskMeter is available with no credit card required.

This is a hypothetical illustration and does not represent an actual investment. The opinions in this commentary are those of the author and may not necessarily reflect those held by any affiliated parties. This material contains an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what is believed to be reliable sources.

This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.


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