Are You Playing It Too Safe With Clients' Investments?

Investors’ stated risk tolerances tend to be higher than those implied by the portfolios either they or their financial advisors construct, according to an analysis recently published by the Certified Financial Planner Board of Standards’ Financial Planning Review.

The headline finding of the new paper suggests that advisors are systemically investing their clients’ assets more conservatively than would be implied by their stated risk tolerance. According to the paper’s authors, this conclusion pushes back against the suggestion that financial advisors are prone to exposing their clients to excess or undue risk. In fact, the opposite appears to be true — and that may itself be a problem.

The authors of the analysis include John Thompson of the University of British Columbia; Longlong Feng of Western University in London, Ontario; Adam Metzler and R. Mark Reesor of Wilfrid Laurier University; and Chuck Grace of the Ivey Business School.

According to the researchers, the systematic under-risking of portfolios implies a potential “efficiency cost” ultimately borne by individual investors and by society at large. Given the increased degree of responsibility that individual workers now bear with respect to providing for their own retirement security, the analysis posits that many investors may not be taking as much investment risk as they reasonably could.

This means, in turn, that many investors may have to rely further on social insurance programs and other sources of support.

The authors conclude that the financial advisor community could be better off utilizing a statistical concept they refer to as “value-at-risk” to more accurately measure what the authors refer to as “elicited risk” and “revealed risk.” This approach allows advisors to accurately identify the discrepancy between stated risk tolerances and actual risk-taking, the authors claim, thereby providing a roadmap for determining whether clients are over-risked or under-risked.

The Limits of Risk Questionnaires

As the paper authors note, financial advisors commonly use questionnaires and discussions with clients to determine investment goals, elicit risk preferences and establish a suitable portfolio allocation for different risk categories. At the same time, financial institutions generally assign risk ratings to their financial products, and advisors use these ratings to categorize products into the various risk categories used for portfolio allocation.

“This information, obtained through questionnaires and client-advisor discussions, includes demographics, financial goals, and risk preference and tolerance attributes,” the paper states. “Using know-your-client information, advisors establish a suitable distribution of wealth across broad risk categories.”

According to the researchers, it is important to note that the initial risk assessment phase does not represent the development of an actual portfolio construction strategy, since it does not address specific products or asset classes. They call this initial risk analysis the client’s “elicited risk.”

The next step is for advisors, armed with the elicited risk preference and the risk classification of financial products, to actually help their clients select and maintain a portfolio of real-world assets. The researchers call the selected portfolio’s risk “revealed risk,” and as noted, this second measure is routinely different from elicited risk.

“We find that elicited risk is typically higher than revealed risk, in agreement with industry protocols treating elicited risk as an upper bound,” the analysis states. “Advisors tend to put clients into medium or higher elicited risks, but consistently medium or lower risk portfolios.”

A Better Approach

The authors go on to offer up a technical review of what they see as a superior approach to risk assessments, based on the general financial concept of “value-at-risk.” Broadly speaking, value-at-risk can be understood as a statistical measure of the riskiness of financial entities or portfolios of assets. It is defined as the “maximum dollar amount expected to be lost over a given time horizon, at a pre-defined confidence level.”

According to the authors, advisors can use this approach to better understand each client’s current portfolio risk in terms of a dollar amount or revealed percentage, and they can also understand how each client’s stated risk aligns with any prefabricated or customized investor portfolios.

“We believe this will improve communications with the client and help clients understand better how much of their wealth is at risk and what a ‘significant’ loss looks like,” the paper explains. “Additionally, an advisor can quickly understand how a change in the overall assets across their advising firm will affect all of their client’s risk positions and easily detect any clients that may be put into a risky position that they are not comfortable with.”

According to the paper, advisors could use other risk measures to better find the values of elicited and revealed risk, as well as any discrepancy between them. For example, they could use an analysis of projected portfolio volatility, but this measure does not account for expected returns, and it places equal weight on gains and losses.

Ultimately, the advisors in the study appear to manage risk actively on behalf of their clients, and that is a positive thing, but the process can be improved.

“Our work suggests that advisors play an essential role in terms of the perennial balance  between risk and return, and that an advisor’s role is more complex than the simple pursuit of alpha,” the paper states. “Do our findings suggest negative consequences for investors? We find that advisors are systemically safe and conservative and thus do not appear to expose clients to undue risk.”

That is good news for clients seeking to preserve capital, but some clients may not be exposed to enough risk to achieve their expressed goals when seeking to maximize growth. As the authors conclude, under-risked accounts may be just as problematic as over-risked accounts, though they are easier for advisors to defend to regulators and lawyers, given there is no significant loss of funds.

“A negative outcome might be older clients who can preserve their capital but are unable to achieve investment incomes that allow them to maintain their lifestyles,” the paper concludes. “This general under-risking by advisors for their clients is a systematic bias.”

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