Category Archives: General

3 Challenges Financial Advisors Face When Discovering Their Client’s Risk Tolerance

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.

7272% 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.

3. Compliance

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.

What You Must Know About Risk Before Making a Financial Plan

Risk DiceUnderstanding financial risk can be a complex subject mostly because everyone seems to have a different definition. Traditionally risk has been defined by a dry and mathematical term called volatility. Volatility being a measure of the dispersion of returns for an investment. Essentially, the amount of uncertainty we have about how the value of an asset may change.

Read the rest at the Smart Financial Planning Blog



The Best Asset Allocation Ever? The UK Permanent Portfolio

As a financial adviser you get judged on many metrics but chief among them is portfolio performance. Which client would want a financial adviser who routinely looses them money?

Depending on what you read asset allocation determines between 40%-100% of portfolio performance (The CFA institute has a great article on this over here). So whichever way you spin it, it’s pretty important.  Modern Portfolio Theory and the “Efficient Frontier” have left most of us with a sliding scale stock/bond fund split. 80/20 for people under 30 and the reverse for people well into their retirement.

We’ve left individual stock picking to the brave and clueless and yet when events like the financial crisis happen and clients loose 30-40% of their portfolio value in a matter of weeks we wonder if it was wise to put such a large amount of our portfolio in one asset class.

After all in our globalized world equity is equity. Is Lloyds Banking Group really uncorrelated with Credit Agricole. Enter the Permanent Portfolio devised by Harry Browne.

If I told you there was a portfolio that from 1972 to 2011 returned 11.4% annually, only had 3 down years (the worst being 4.8%) and had consistently beaten inflation would that make you sit up straight in your chair? How about the fact that during the worst financial crisis in the last 80 years 2008/2009 the portfolio returned 5.9% and 8.9% respectively while equity rich portfolios plunged.

Sure, past performance is no indication of future performance and I am sure I could back test any crazy portfolio mix to get a 1000% return but when you think about it logically the Permanent Portfolio has strong foundations.  Let’s dig in….

Permanent Portfolio

The portfolio holds an equal mix of UK equity, long dated Gilts, gold and cash. The portfolio is designed to take advantage of all the major cycles of the economy. Equity for prosperity, long dated gilts for deflation, gold for inflation and cash for a recession/depression.

At any one time the economy will be in one of these four phases ensuring at least a quarter of your portfolio is in the ascendency. Conversely, if there is a major stock market crash only 25% of your portfolio is likely to be affected.

What is remarkable about the Permanent Portfolio is its steady performance over the last four decades. It typically beats inflation by 3-4% without wild swings up and down. On a pure return basis it slightly under performs the traditional 80/20 equity bond split by about 0.3-0.6% but with a lot less volatility and down years.

You don’t get huge crashes and large upswings. It is steady and consistent. Despite these facts there are many objections to portfolio make up. Let me cover the three most common.

Question 1 – 25% Gold! Are you nuts?!?!

The premise of the Permanent Portfolio is that nobody knows what is going to happen in the future so you should be equally prepared for each outcome. For all we know a 70’s style economic malaise might be around the corner. Gold was a great asset to hold in the 70’s.

It’s true that gold doesn’t produce any dividends but it has been a store of value used for millennia. Why do you think central banks store billions in their vaults? What is special about gold is that it tends to appreciate in inflationary periods (few assets do that) and you can even use it as legal tender.

Question 2 – Where is the international equity allocation?

The portfolio is designed to meet inflation plus 3+% in your country of residence. If you add international stocks you start being subject to the economic conditions in a far away land in which you do not live. That being said many proponents of the Permanent Portfolio have a second allocation where they include some international stocks to take advantage of emerging markets or the biggest economy in the world (USA).

 Question 3 – How do I construct such a portfolio?

Simply index and leave it be. Here are a few options based on ease and expense.

UK Equity – Vanguard FTSE UK Equity Index Fund

Long Dated Gilts – Vanguard UK Long Duration Gilt Index Fund

Gold – EFT Securities – Physical Gold ETF

Cash – Bank savings account

If you want to learn more (and there is a lot more to learn) I encourage you to pick up a recent book about the Permanent Portfolio or visit the forum. If you still have doubts then read these two amazing forum posts where Modern Portfolio/Efficient Frontier supporters debate with Permanent Portfolio proponents. The posts are here and here. I’ve been studying the portfolio for the last year and I’ve been very impressed with its theoretical foundations and real returns.

3 Ways to Protect your Clients from Liquidity Risk

Nother Rock Liquidity RiskBefore the 2008/2009 financial crisis you probably didn’t worry too much about your client’s liquidity risk. Getting their money out would be as simple as putting it in. That was until Northern Rock happened. Given what unfolded and the recent troubles in Cyprus, liquidity is something everyone should be concerned about when choosing investments.  Below we offer three ways to keep your client’s money safe.

1. Ask Them How Much Risk They Are Willing To Take

The first step is to ask your client’s how they would react during a liquidity crisis. At Pocket Risk we include such a question in our risk profiling assessment.

In the event of an emergency (e.g. personal or financial crisis) I want to get out of some of my investments within a few days.”

Followed by which client’s can decide on their level of agreement. You don’t need to ask this exact question but you should know how they would react if they couldn’t get their money out quickly.  During the financial crisis investors in “safe” money market funds had to wait almost three years to get their money back. Can your client wait three years to access their cash? Even if they could, would they be happy? Unlikely. Therefore, you should find out your client’s liquidity risk profile (what we would consider a subset of tolerance/attitude to risk).

Once you understand your client’s tolerance you can move forward and recommend tailored investment decisions.

2. Limit Counterparty Risk

From ETFs, to platforms to online exchanges. All of this wondrous technology has made investing quicker and cheaper. However, it takes us further away from our investments. For example, that GILT fund you bought for your client, is it in their name or the “street name” of your broker. What happens when a computer crashes and they loose the records? Will anyone be able to discover who owned what? These events are unlikely but not impossible and we should prepare for such outcomes.

Invest your client’s money in reputable firms with a solid track record like Vanguard. Avoid anything too synthetic. Here is a classic example of an Exchange Traded Commodity. Let’s see how many counterparties we can find if we invested in this asset (highlighted in red).

“ETFS EUR Daily Hedged Agriculture DJ-UBS EDSM (00XJ) is designed to track the Dow Jones-UBS Agriculture Subindex Euro Hedged Daily plus a collateral return. The product enables EUR investors to gain exposure to a total return investment in commodity futures with a daily hedge against movements in the EUR/USD exchange rate. The ETC is backed by contracts (fully funded swaps) with counterparties whose payment obligations are backed by collateral which is marked to market daily. The collateral is held in pledge accounts at The Bank of New York Mellon. Details of the collateral held are available at:”

  1. Financial Planning Firm – 1st Counterparty
  2. Broker/Platform – 2nd Counterparty
  3. ETFS Limited – 3rd Counterparty who manages this asset
  4. Dow Jones-UBS Index – 4th Counterparty – If something goes wrong with the index how will it affect my client?
  5. Fully funded swaps? Various other counterparties – 5th Counterparty
  6. Bank of New York Mellon – 6th Counterparty

Ok, I will stop and I didn’t even mention exchanges or the banks of some of the counterparties. It’s endless but you get the point, limit the steps from your client to their money.

3. Diversification

Diversification has its obvious return benefits but it also has its liquidity benefits. Eliminating counterparty risk is impossible unless your client keeps their money under the bed. So your best bet is to eliminate any dependency on a single business, product, platform, process or decision maker. As an adviser, having to deal with multiple products, platforms and technologies is not efficient for your business but it protects your clients from the worst.

With the Cyprus crisis the European Union has all but stated that any deposits over $100,000 are not safe. If your client has over that amount in cash deposits they should spread it across the different banking groups (click here for the full list). They should be safe for up to £850,000 by our calculation.

Lastly, just to step up the doomsday scenario, we must ask whether we can even trust our own government. Paul Mason from the BBC doesn’t seem to think so. So it’s probably wise to have some money/investments offshore too. Don’t forget financial repression has happened before.