When people win, they like risk. When they lose, they hate it. If only it were easier to translate that knowledge into an investment strategy or an asset allocation plan!
Since the market meltdown, investment advisors have been searching for better ways to measure how much risk really makes sense for each client. Some swear by a particular risk questionnaire; others rely on free-ranging dialogues, while others are no doubt completely at sea.
It’s an important issue because many clients expect their advisor to intuit how they feel about risk, even if they can’t express it. After losing a quarter (or more) of their portfolios’ value in a few harrowing months, many clients who once considered themselves “very risk tolerant” are angry, disillusioned, and distrustful.
I can’t help thinking that it represents a tremendous opportunity for financial professionals who are skilled in listening carefully to clients, building a strong bond with them, and creating a plan that meets their financial and emotional needs. As part of this process, each client’s risk tolerance needs to be more accurately assessed. But how?
The Three Faces of Risk
“A lot of risk questionnaires are built wrong in general, asking the wrong questions and getting the wrong answers,” Michael Kitces told me. Kitces, who is director of research for Pinnacle Advisory Group in Columbia, Maryland, and publishes The Kitces Report, has done a great deal of thinking about risk tolerance.
He argues that there’s more than one piece to this puzzle. The obvious piece is risk capacity, which is based on the client’s financial situation. Advisors are typically familiar with the factors that influence this assessment, such as length of time to retirement, availability of guaranteed income, ability to self-insure for long-term care, and so on. With Monte Carlo projections, it’s possible to estimate how much investment risk the client needs to take to improve the odds of attaining his or her goals.
However, there is often a disconnect between one’s liking for risk and one’s financial capacity to bear it. For example, a client may insist that he wants to take no risk at all, even though risk-taking is his only hope of achieving his goals. Or you may encounter the opposite, as Bobbie Munroe, a planner and owner of Fraser Financial in Atlanta, points out: “Sometimes a client is well prepared for retirement because they have a high risk tolerance and invested somewhat aggressively during the accumulation phase. As they enter retirement they might not need to take much risk, as all their goals are provided for. Following their prior style could be the only thing that would jeopardize their plan. Yet they still want to take risk.”
This disconnect can easily happen, Kitces observes, when a questionnaire mixes queries about risk capacity with others about risk attitude (people’s willingness to accept the potential fear and anxiety that accompany risk). After combining these questions, they average the scores to come out with a nonsense number.
For example, suppose you have a client with a very low risk attitude. If his portfolio were exposed to so much risk that it lost 20%, he would feel like jumping out of a 10-story building. Yet if this risk-averse client has a high risk capacity, a flawed questionnaire might average the two and recommend that he take moderate risk. Will he feel better if his portfolio loses only 10%? Maybe he’ll only want to jump out of a five-story building!
In order to determine how much risk a client can handle, it’s essential to differentiate risk capacity from risk attitude and explore these two domains separately. “Don’t ever give them a portfolio that crosses the line into fear and anxiety they can’t tolerate,” Kitces warns. Advisors who disregard this rule tend to end up being either abandoned or even sued by unhappy clients.
Risk’s Changing Contours
There is a third piece of the puzzle that Kitces identifies: risk perception, which gauges how clients view the riskiness of various kinds of investments. Risk perception changes frequently (and sometimes irrationally), depending on whether markets are up or down and what sector is hot at the moment. For example, during the technology bubble of the late 1990s, even risk-averse clients wanted to invest heavily in tech stocks. Why? Because they perceived that these stocks weren’t risky at all.
An advisor’s education and communication skills can be instrumental in changing risk perceptions over the life of a relationship. A good advisor would have educated his or her clients that tech stocks’ wild upswing didn’t make them safe. More recently, clients riding the long bull market needed to be educated about the risk of falling short of their goals if the market imploded.
As Kitces puts it, “Because we are not terribly rational, and because we have lots of biases that constantly cause us to misjudge risk, in a bull market clients think that being 100% in stocks is safe and that stocks will go up forever. In a bear market, they think that stocks will probably go down to zero. Both are totally irrational and untrue.” This flipflop is not due to a change in the client’s risk attitude (which Kitces believes is fairly constant), but to a shift in risk perception based on current trends.
John Comer, president of Comer Consulting in Plymouth, Minnesota, a marketing consultant to financial planners, cites a personal example of the changeability of risk perceptions: “I used to live in Brooklyn, New York, and felt very comfortable in the neighborhood. One day I was mugged coming home, and from then on I started to look over my shoulder as I walked through the neighborhood. A lot of your clients feel like they have been mugged, and they are looking over their shoulder more than they did two years ago.”
One of the advisors Comer works with had a similar incident with one of his clients. The client originally came into the relationship insisting on conservative investments, due to issues with a previous advisor. However, over five years of strong markets he became disenchanted with his portfolio’s meager returns. Of course the financial advisor said he could adjust the mix, but it was too late. The client left.
As therapeutic educators, financial advisors have to continuously manage clients’ expectations and fears in order to counter what Kitces calls (with a nod to Alan Greenspan) “the irrational exuberance of bull markets and the irrational fear of bear markets.” To ascertain their present risk perceptions, you need to ask them frequently, “How risky do you think the stock market is these days?” and “What do you think of your portfolio?” Even if you’ve determined their risk attitude (and risk capacity) previously, they may be misjudging the current amount of risk in their investments. That’s where the job of educating them beyond their prejudices, fears, and irrationalities comes in—a long-term, ongoing process.
Kitces concludes, “If you find your clients’ behavior around risk is constantly changing, you’re probably not doing enough communicating and educating to help them move to more rational attitudes.”
In short, don’t get so wrapped up in the back end of the process—creating a reduced-risk portfolio for your clients—that you overlook the front end, which is learning how they feel. As Karen Hube noted in a September 2, 2009 article in The Wall Street Journal: “Some advisers are dumping targeted investments and choosing broad index funds, and others [are] stepping up their tactical bets. That echoes the perennial debate over whether to take a passive or active approach to investing, says Deanna Sharpe, associate professor of personal financial planning at the University of Missouri in Columbia…More important than classifying a planner as an active or passive investor, Dr. Sharpe says, is ‘actively managing your relationship with those managing your money.’”
Managing Investments, or Investors?
Kol Birke is already on that wavelength. He tells the advisors he works with, “You need to start breaking out your management of investments from your management of investors.” A financial behavior specialist in the home office of independent broker/dealer Commonwealth Financial in Waltham, Massachusetts, Birke defines his mission as arming advisors with the tools to help their clients lead their best lives. To better manage investors’ vulnerability to risk, he suggests that advisors coach them on three levels: learn, prepare, and deploy.
Learn about your clients’ style as investors. Are they risk avoiders, risk-takers, or in between? How do they handle stress? How hands-on do they want to be in choosing investments? How do they prefer you to communicate with them?
Prepare them for tough times. If they’ve experienced a rough financial period in the past, what helped them get through it? What do they know now that they wish they’d known then? Would they like you to remind them of that wisdom if tough times roll around again? The process of helping clients harness their own resilience is an excellent and oft-forgotten piece of the relationship. It may help you counteract a client’s later tendencies toward panic, paralysis, or rash action.
Another part of “Prepare” is helping clients develop what Birke calls a “non-financial emergency fund.” Ask what resources they have to draw on in a stressful situation: friends, family, pets, community, faith, creative outlets, physical activities? Provide resource lists to assist clients in building up this “fund.”
Deploy these resources if your clients encounter challenges. In tough times, they’ll be able to draw not just from their financial accounts, but from this non-financial emergency fund as well.
Birke and Tere D’Amato, VP of advanced planning for Commonwealth, believe that investment risk management needs to consider three factors: risk capacity, goals, and style. Capacity is “what I have,” not just assets and liabilities, but the predictability of income, the amount of emergency cash, the number of dependents, fixed and variable expenses, the adequacy of insurance coverage.
On the other side is “what I want”: the goals the client hopes to fund. In defining these goals, Birke reminded me of Barry Schwartz’s excellent book about decision theory, The Paradox of Choice: Why More Is Less (Harper Perennial, 2005). In Schwartz’s terminology, people tend to be either maximizers, who want only the best, or “satisficers,” who are willing to settle for good enough. Birke feels that maximizing is most people’s default behavior. I agree: in our endlessly expansive, all-too-acquisitive, short-term-oriented culture, many people believe “more is better” instead of saying to themselves, “what I do have is enough.”
Birke suggests that after seeing the dangers of trying to maximize in the market, more of us will become satisficers, content when we have enough. On the investment side, this would translate to a level of risk that declines over time. “As people get closer to their goals,” he says, “advisors should ensure that they take less and less risk.”