I just spent the last 10 weeks interviewing 76 financial advisors across the U.S. I asked them about their risk tolerance process. Specifically, how they discover the right level of investment risk for their clients. The results were varied but the challenges were the same.
Firstly, advisors were struggling to balance the investment needs of their clients with their risk tolerance. Secondly, they were often happy with their discussion process but thought it could have more rigor. Finally, compliance was a common complaint but not in the way you would expect. Let’s dig in and unpack some of these challenges.
1. Balancing Your Client’s Financial Needs With Their Risk Tolerance.
72% of the advisors I spoke to first calculated their client’s financial needs before considering their client’s risk tolerance. Their role was often to ensure a client had enough money for retirement. This could necessitate an asset allocation with more volatility than a client could stomach but was necessary to ensure they met their future income goals.
At this point some advisors would say to me…“What is the point of a risk tolerance questionnaire if I am just going to invest based on need? Isn’t this simply a case of CYA (covering your ass)?” At which point I would draw on the experience of other advisors I had spoken to who had lost clients during the 2008 financial crisis. They regretted not having a thorough understanding of a client’s risk tolerance before the crisis. Since they didn’t know their clients intimately, they were unable to set expectations and manage them through the downturn.
As has been well documented, investment risk is a mix of tolerance, need and capacity and all of these have to be considered when developing an investment portfolio. Getting the balance right is a challenge for advisors but ignoring one of these factors does not solve the financial planning process.
2. Face-to-Face Client Discussion
A risk tolerance questionnaire alone cannot solve the investment process. Even if it could clients don’t want to feel like a widget on the production line. Advisors are wise to this and enjoy the process of an open-ended discussion with their clients. This is where you can build a relationship and capture details boilerplate questionnaires cannot.
However, an open-ended discussion process in a firm of multiple advisors can often lead to a lack of consistency and objectivity. One advisor admitted to me that if one of his employees left the company they would loose detailed knowledge about their client’s investment preferences because it was all in his head. A scary thought.
78% of the advisors I spoke to admitted that they could probably improve their record keeping and make it more systematic. A few advisors recorded their discussions on a dictaphone or used mind mapping software but the majority resorted to scribbling notes on paper while their client did the talking.
Given the litigious culture we find ourselves in, it’s not a surprise that advisors are afraid of lawsuits. Amazingly, I found 9 of the 76 advisors were afraid of too much documentation in case it was used against them in a lawsuit. Sure, they wanted to understand their client’s risk tolerance but they didn’t want too much evidence of it!
The majority however, appreciated that meeting regulatory demands and keeping accurate records would most likely protect them from lawsuits and not the other way around.
Solving These Challenges
At first thought there are clearly a few things that can be done. For example using a robust risk tolerance questionnaire, having a clear and consistent on boarding process for new clients and keeping full and accurate records. But this is just the start. Over the next few days, weeks and months I will be tackling these challenges on this blog. Please subscribe on the right for future email updates and share this blog with your friends if you liked it.