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Kitces: The Big Problem With ‘Risk Tolerance’

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What You Need to Know

  • There is a big difference between a client's risk capacity and their risk attitude and risk perception.
  • Advisors should keep asking the questions they always have to gauge risk but start asking them in different ways.
  • Risk capacity and risk attitude must be aligned correctly.

It is important for advisors to “reframe” and “think differently about the risk tolerance paradigm” when it comes to their clients because the traditional approach often does not work, according to Michael Kitces, head of planning strategy for Buckingham Wealth Partners and co-founder of XY Planning Network.

As part of that approach, advisors have typically asked a series of initial questions to get a handle on their clients’ risk tolerance levels, he said Tuesday during the webinar “Rethinking Risk Tolerance.”

Those questions have traditionally dealt with: the client’s time horizon (whether it’s a short-term or long-term strategy that is needed), the need for income, availability of other assets, the client’s knowledge level about investments, and the client’s willingness to take risk (especially in down markets), he noted.

The portfolio that an advisor creates for the client is then traditionally based on the risk “score” for that client based on how they answered those questions. The lower the score, the more conservative the portfolio will tend to be, Kitces pointed out.

Although those questions are all “incredibly important” to ask clients, advisors should start thinking a little differently about them and place them into different categories, he said.

For one thing, time horizon, need for income and availability of other assets are all related to a client’s risk capacity — their “financial capacity to take risk,” Kitces noted. What that comes down to is if something bad happens, “would your goals be in trouble?” he said.

Higher-level knowledge about investments, meanwhile, is related to the client’s risk perception and a willingness to take risk in a down market is related to the client’s risk attitude, or tolerance level, he said.

2 Client Cases

As examples, Kitces pointed to a male investor with a high capacity for risk and a female investor with a low capacity for risk. The man needs income in 15 years, has an income goal of $15,000 a year, and his future portfolio is projected to be worth $1.5 million. The woman, on the other hand, needs income of $65,000 a year starting now from a $1 million portfolio.

“If something bad happens, Betty is doomed,” but John would be fine in those scenarios, Kitces said.

Once you get beyond those details, however, neither of those investors’ risk tolerance levels mean they’re open to taking risk, whether they could afford to or not, Kitces noted, adding both of them are very conservative investors who don’t like to lose money.

By asking all the traditional questions, John, who warned he would sue any advisor who lost his money, would end up with a moderate growth portfolio, while Betty would get a conservative portfolio, Kitces said.

With that moderate growth portfolio, however, “it’s literally just a matter of time before whatever market volatility happens … John either fires you or sues you,” Kitces warned.

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That is “not a good scenario” because “we are setting up John for personal crisis and angst that he didn’t even need,” Kitces said. Betty, meanwhile, will get the lowest risk tolerance score, have all fixed income investments and have “guaranteed failure” in her retirement plan, Kitces added.

The Problems With the Traditional Method

Those are the “problems” with the traditional way of gauging risk tolerance, according to Kitces. The “fundamental problem” for Betty is that her risk attitude and risk capacity are “misaligned.” What she needs is a “different goal,” and the advisor must “reset” that goal, he said.

Kitces suggested that advisors measure risk capacity using the financial planning process and that the key capacity measures be incorporated in retirement planning analysis.

When it comes to risk attitude and tolerance, he suggested advisors use a questionnaire to measure it and possibly incorporate aspects from the conversation with the client.

Written questions are often better than asking questions in a conversation because there is less potential for unintended bias in the way an advisor asks the question and less risk of the planner affecting the client’s answers, Kitces said.

Last, the client’s risk perception is critical up front and as part of the ongoing process, and it should be used as a key aspect of managing the client’s expectations, Kitces said.

5 Main Takeaways

1. Risk capacity must be measured separately from risk attitude/tolerance.

2. Risk capacity is evaluated as part of the financial planning process.

3.  Risk attitude is best evaluated via a “psychometrically” designed questionnaire.

4. Risk perception shifts and must be managed constantly.

5. An integrated approach allows the planner to optimally address the client’s overall risk profile.

Pictured: Michael Kitces, head of planning strategy for Buckingham Wealth Partners.