From the May 2010 issue of Boomer Market Advisor • Subscribe!

Don't tolerate emotion in your clients' decision-making

The bull market that ended in 2008 led many investors to grossly overestimate their tolerance for market risk, and the subsequent decline became an eye-opener for many. While on paper they may have had the means to weather a storm, psychologically, many found the market decline more harrowing than they expected. Advisors found themselves managing client expectations that had been pushed higher by media exuberance only to face the reality that every investment does indeed have its risks.

Retirees have different needs and concerns for retirement. Traditional risk profiling methods have attempted to quantify a client's sensitivity to loss in a portfolio. These tools tend to work better during the accumulation years than they do in distribution years, when clients have less time and fewer new assets coming in (such as salaries) to make up for losses. In addition, traditional risk profiling typically relied on the numbers: assets, income, growth potential, market risk, inflation risk, etc.

While that kind of analysis can certainly lead to providing the client a "number," it doesn't address the psychological needs of the client. It doesn't answer the question of the psychological impact on the client if the worst case scenario comes to pass. With the high emotional component involved in decision making regarding investments, psychological stress can lead clients to make poor decisions at critical points.

Client responses to the market decline of 2008-2009 have shown the need for a risk profiling method that takes into account the client's emotional response to risk. Obtaining a more complete picture of the client's risk tolerance--financial and psychological--requires expanding the traditional risk tolerance tool's objective questions regarding the client's current financial risk with the addition of subjective questions regarding the client's feelings about money and risk.

The answers to these questions can then help the advisor determine the percentage of a client's retirement income that should potentially come from investment products with a guarantee, such as fixed-income products or annuities. For example, the objective questions would include:

  • Percentage of investable assets committed to producing income. The higher the percentage of assets required to produce the income stream, the more a guaranteed product may be needed. Providing too much guaranteed income, however, can limit liquidity if a financial emergency were to arise.
  • Percentage of income that is required for basic necessities versus discretionary spending. The higher the percentage needed for basic necessities, the more the client should consider a guaranteed income stream. Those clients with large discretionary needs can afford to reduce their retirement income stream if market conditions warrant.
  • Expectations of inflation adjustments. Clients who expect their income needs to decrease or stay about the same can lean towards a guaranteed income stream, as inflation adjustment is less of a concern. Clients needing income to increase at a rate equal to or greater than inflation may need to take more risk to achieve their desired income stream.
  • Percentage of income received from guaranteed sources. The higher the percentage of income received from guaranteed sources (pensions, Social Security, etc.), the less a client might need his or her additional income stream guaranteed.

The subjective questions would be designed to establish the client's position on:

  • Having a guarantee
  • Leaving assets to their heirs or favorite charity
  • Working during their retirement years
  • Outliving their income stream
  • Sticking with the plan

Securities America developed exactly such a risk tolerance tool in 2007. Advisors tell us that clients with whom they used the ROI Profile in conjunction with our other income distribution tools, including a time-segmented income distribution model, were less emotional during the latest market downturn and were more likely to stick to their long-term plan than their other clients. Those results would seem to validate the concept that addressing a client's psychological comfort level with risk is just as important as measuring his or her financial tolerance. And comfortable clients are usually happier clients.

Paul R. Lofties, CFP(R), ChFC(R), is Vice President of Wealth Management & Acquisitions for Securities America, Inc. Member FINRA/SIPC. He can also be heard on the "Master Series" podcasts on AdvisorPod.com, which focuses on providing insight into the business practices of the industry's elite financial advisors.

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