You would expect the individual to get the outcome that matches their colour (see image below), i.e. the low-risk tolerant individual (top row) should get all (or mostly) dark blue outcomes. But we don’t see the colours matching. Our low-to-medium risk tolerant individual (second row) had a high-risk tolerance outcome (turquoise). And our high-risk tolerant individual (bottom row) only had 25% of its outcomes matching that risk tolerance.
The questionnaires tended to underweight a person’s risk tolerance. And there was no consistency.
We also picked up some other problems in the questionnaires: a lot of redundancy and self-assessment. Self-assessments are not ideal. No-one knows how they are going to feel about losing money – until they lose money! Furthermore, there weren’t any questions that assessed personality type or financial literacy.
Pause for a second here – think about the questionnaires or tools you are using. Do you think they are appropriate? Are they getting it right? Think critically about what you are trying to assess and why.
Risk tolerance questionnaires are flawed. Thus, there is a vital role to be played by the financial planner. To do that, you need to read your client’s behaviour, ask the right questions, and manage your own biases.
And while we are talking about risk tolerance, that doesn’t necessarily mean it should be the starting point. Let me explain.
If you start with assessing risk tolerance, the next natural step is to advise an asset allocation based on that. That asset allocation will then determine the client’s return, which dictates their lifestyle.
Let’s switch that around.
What lifestyle does your client want? What returns do they need to earn to live that lifestyle? What assets do they need to invest in to earn those returns? And finally, what associated risk is then required?
This is where it starts to get interesting. If your client’s risk tolerance matches the risk that is required – there is no problem. But if that is not the case, how do you manage that misalignment?
Here are some key things to consider in your client interactions:
1. How do they define risk?
I am generalising, but in most instances, when I talk to someone about risk, they immediately say things like, “I can’t afford to lose my money.” That is not risk aversion, right? That is loss aversion. It is different. It speaks to the client’s capacity to handle a loss.
Make sure you are speaking about risk from the client’s perspective. Use terms and examples that they understand.
Make sure you are speaking about risk from the client’s perspective.
2. Do they realise that risk is inevitable?
If you ask someone if they want to experience pain after surgery, they will obviously say, “No.” But pain is inevitable. If you need the surgery, you will push through the pain. Likewise, risk is inevitable. You need to tolerate it to achieve the returns you want.
This speaks to client education. Running the numbers on what returns are needed is the easy part. Your value-add to your client is relational.
3. Don’t give them too many options.
As humans, we struggle with information overload. And when that information is difficult to understand, it is even more perilous. Value your expertise! Believe in your ability to advise appropriately.
You know the answer… but your role is to manage your client’s behaviour and mindset… and that will only come with time (if you are understanding them properly). But it is well worth the investment.