Category Archives: Risk Tolerance

You’re Using Your Risk Tolerance Questionnaire Wrong

Risk Tolerance QuestionnaireMost risk tolerance questionnaires get a bad rap. For many advisers, they are simply a compliance tool to appease the regulator. They add some value, but if it weren’t mandated, they probably wouldn’t use them. This negative mindset is rightly deserved due to the abusive use of risk questionnaires. Let’s get a few things straight…

  1. Risk questionnaires cannot tell you exactly how to invest.
  2. Risk questionnaires cannot cover the entire suitability process.
  3. Risk questionnaires cannot solely be used for prospecting.

The true purpose of a risk questionnaire is to help you know your client so you ask intelligent questions and recommend the best investments. Knowing your client entails understanding their goals, psychological risk tolerance, capacity for loss and behavioral biases. You cannot capture all of this in a questionnaire.

Investing should be goals driven but instead it’s compliance driven

Risk questionnaires should help you recommend investments and handhold clients during market ups and downs. Not prescribe allocations and securities. The FCA hinted this in their Financial Advice Market review published in March. A questionnaire cannot challenge a client’s misunderstandings or mistakes. This is what being an adviser is all about. Only you can do this.

The regulator has attempted to legislate trust between you and your clients but we know that’s impossible. It has resulted in the bizarre outcome where people are invested according to “what would pass an audit” instead of their long-term goals.

So what’s the solution? It’s twofold.

  1. Ultimately, the financial advice market will need to increase its standing in society so it has more trust and less need for regulation. Perhaps the greatest trust builder being increased education and professionalism across the ranks (which is happening). At the beginning of the last century medical doctors were widely decried for their quack cures and empty promises. A few decades later they were the most esteemed profession in the country. This can happen with financial advisers.
  1. On the risk tolerance questionnaire side, you should be ready to challenge the results of a risk questionnaire if it suits your clients’ greater long-term interest. Human judgment shouldn’t be completely dismissed. It just needs to be thought through and documented. Admittedly, going through a detailed question and answer session with a client is less efficient than a questionnaire but it will help you learn about your client’s overall profile in a way a risk questionnaire cannot.

As someone who leads a company that creates a risk tolerance questionnaire for advisers you might think it odd that I call out the limitations. On the contrary, I think this draws to attention the qualities and uses of an effective questionnaire. It should help you understand a client’s goals, psychological risk tolerance, capacity for loss and behavioral biases so you can ask intelligent questions and guide clients towards their goals. It should act as a client-friendly, 3rd party check in your process to ensure you don’t succumb to your own behavioral biases. Does your risk tolerance questionnaire do this?

[Introducing Pocket Risk 2] Why Risk Tolerance Questionnaires Should Not Be Used For Prospecting

In recent years there has been a plethora of risk tolerance tools releasing features to help advisors acquire more clients. The theory goes by assessing a client’s risk tolerance we can know what investments best suit their psychology, a portfolio they will “stick with”.

However, this contradicts the true purpose of a financial advisor, which is to help clients achieve their long-term financial goals. Simply investing along the lines of someone’s psychology could result in a plan that has too little risk or too much.

The Customer Acquisition Challenge

Advisors like these customer acquisition features because they believe it will bring in more clients. But the real customer acquisition cure for advisors is not better technology but more trust and awareness. See research and commentary here and here.

The primary purpose of a risk questionnaire is to educate an advisor about a client’s risk tolerance, risk capacity and risk needs (goals). With this information an advisor can build a plan likely to hit the goal, without the client bailing out midway. A client’s psychology should not be ignored but it should definitely not be the main driver of a plan.

Jumping from risk tolerance to investment portfolios without adequate consideration for goals and risk capacity is a recipe for short-term satisfaction and long-term dissatisfaction.

Introducing Pocket Risk 2

Every week, advisors ask us to build more and more “customer acquisition” features. It’s tempting since, we want to make money but it doesn’t feel like the right thing in the long run. The right thing is a tool to educate advisors and clients that promotes good behavior. Since behavior is the primary determinant of investor returns.

We have released a new risk questionnaire that assesses goals, risk tolerance and risk capacity so advisors can collect the information they need to build a plan that works in the long-run.

Our new feature set is about enhancing the financial planning differentiation advisors have today against robo-advisors rather than trying to compete in commoditized investment management technology. The advisory customer acquisition challenge will be won in personalized financial planning, where robo-advisors cannot easily compete.

Click here to take the risk questionnaire

 risk tolerance questionnaire

Client Suitability Compliance: A Comparative Review Of The USA, UK, Canada and Australia

Suitability ComplianceWe can learn a lot from our neighbours, including how to manage a client’s suitability for a certain investments. The U.S., U.K, Canada, Australia and a number of other countries have produced guidelines around client suitability including the use of risk tolerance questionnaires. Below is an overview of where each country stands.

U.S.A. – Financial Industry Regulatory Authority (FINRA) and Securities Exchange Commission (SEC)

FINRA Rule 2111 discusses client suitability when advisors recommend investments. It states advisors must…

have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer’s investment profile. In general, a customer’s investment profile would include the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.

FINRA defines risk tolerance as a client’s “ability and willingness to lose some or all of [the] original investment in exchange for greater potential returns”. This what we would call risk tolerance and risk capacity. With regards to questions and questionnaires FINRA states they must not be “confusing or misleading“. Advisors are not forced to use a risk questionnaire but FINRA recognizes advisors use such tools as a best practice.

Financial Advisors regulated by the SEC are held to the fiduciary standard, meaning they must legally and ethically act in people’s best interest. The SEC provides little specifics on risk questionnaires. However, they do say any presentation of data must be clear and not misleading.

U.K. – Financial Conduct Authority (Formerly the Financial Services Authority)

The UK has the most prescriptive suitability rules in the world. In 2011 the FSA released “Assessing Suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection“. The assessment found that most advisors were not properly assessing client suitability for investment. Their main findings were that…

  • Advisors were not diligently assessing risk tolerance AND risk capacity
  • Advisors were not assessing clients’ investment knowledge and experience
  • Advisors were using poorly constructed questionnaires that could sway clients too far into aggressive risks. Questionnaires did not have enough granularity.

Since this paper was released standards for suitability investment have increased. All UK advisors now have to provide a Suitability Report when recommending investments to clients.

Canada – Investment Industry Regulatory Organization of Canada (IIROC) and Mutual Fund Dealers Association of Canada (MFDA)

Canada has a complex financial regulatory system due it’s decentralized government. Financial regulation happens at the national level and at the provence level. However, the responsibility for client suitability has been led by the IIROC and the MFDA.

The IIROC has a series of KYC (Know Your Client) regulations including the requirement to demonstrate a client’s risk willingness, financial ability, time horizon and investment objectives. There is no specific mention of using a risk questionnaire but KYC forms are encouraged.

MFDA has been significantly more prescriptive and even provided a basic “safe harbor” risk questionnaire for financial advisors. They are the first regulator to talk about the need to measure a client’s risk tolerance, risk capacity and risk needs. Jointly these represent a person’s overall risk profile.

Australia – Australian Securities and Investments Commission

The focus for Australian regulators is that best interests have been applied by the Financial Services Professional (FSPs). Professionals must ensure the financial products they recommend are suitable having regard to each client’s objectives, financial situation and needs. An important part of an FSP’s assessment of a client’s objectives, financial situation and needs is the knowledge of the client’s tolerance to risk.

The regulator goes a step further and states FSPs should “educate their clients about risk and reward” and ensure couples are assessed individually.

ASIC and the Financial Ombudsman are supportive of risk questionnaires but state FSPs should not be 100% dependent on their results. They should use their judgement in conjunction with a questionnaire.

Conclusion

Regulators support and acknowledge the concepts of risk tolerance, risk capacity and risk need. They are increasingly prescriptive about measuring these constructs however, they don’t want a client assessment to become a “check the box” exercise and have thus shied away from developing detailed questionnaires. What they are looking for is consistency, objectivity and diligence when advisors recommend investments to clients.

The Best Risk Tolerance Process For Your Clients

Best Risk ToleranceAssessing your clients’ risk tolerance and overall risk profile (which includes risk capacity, risk needs and behavioral biases) is essential to building suitable portfolios, running an efficient practice and meeting compliance requirements. But what is the ideal way to do it? Tip: It’s not just about having the best risk tolerance questionnaire.

First, let’s define “best”. In my eyes the best risk tolerance process is accurate, fast, inexpensive and pleasurable. Accurate means you can trust the results of your process. Fast means the client can be assessed in less than 30 mins (excluding advisor discussion). Inexpensive means the value should exceed the cost. Lastly, pleasurable means both you and the client should enjoy the process.

Having spoken to thousands of advisors over the years about risk profiling I can say the best risk tolerance process involves the following…

1. Client Education – It’s difficult to  get an accurate result and for clients to enjoy the risk tolerance process if they don’t understand basic financial theory. As I explain in my email course “How To Assess Your Client’s Risk Profile” clients should understand the risk-return tradeoff, the importance of time horizon, and the skill of coping with uncertainty. Without some of these fundamentals, it will be difficult for a client to grasp any risk tolerance questions.

2. Use A Professional Risk Tolerance Questionnaire – This might sound self-serving but a professional questionnaire will improve accuracy and speed. It will also make the experience inexpensive, compared to the time spent asking clients questions and mailing/filing paper questionnaires. Creating your own questionnaire might seem like a good way to save money but you take a big risk on accuracy and speed. With online questionnaires prospects and clients can do it online before they come to your office. It’s very convenient.

3. Complete Annual Reviews – Clients change. Not overnight but typically as the years pass. It’s a good idea to track how your clients are doing every year.

4. Continuous Communication and Education – I am a big fan of newsletters for so many reasons. Chief among them is that they can serve as an antidote to the misinformation in the media. Slowly educating your clients over the months and years about financial markets will give them the mental wherewithal to deal with market corrections. I particularly like the newsletter produced by Lexington Wealth.

To conclude, as an advisor, you must appreciate the risk tolerance assessment process is always ongoing in the background. You can’t assess once and neglect it for years. Clients need to be educated and they undoubtedly change over the years (although this is likely to be slight). So as part of your annual reviews spare some time to discuss your clients’ risk tolerance and overall profile.

Why You Should (And Shouldn’t) Use A Risk Tolerance Questionnaire

Risk Tolerance Question MarkAll financial advisors collect Know Your Client (KYC) information about their clients. Not only is it a regulatory requirement, it’s good business. It helps you build a winning investment approach by requiring you to collect your clients vitals.

History Of Risk Questionnaires

Unfortunately, as KYC requirements expanded in the 90’s and 2000’s advisors increasingly had to use ineffective, boilerplate risk questionnaires to meet regulatory requirements. A robust and widely available approach did not exist. This gave risk questionnaires a bad reputation. Advisors did not want to use a tool that was ineffective just to please the regulators but they had no choice. It was that, or go out of business.

Due to the forced regulatory antecedents of risk questionnaires some advisors chose to avoid as much as possible. But times have changed and we now have comprehensive risk profile questionnaires that are effective, compliant and measure more than risk tolerance (they can measure risk capacity, and goals). Below I explain why you should use a risk profile questionnaire. However, it wouldn’t be fair to talk about “why you should” without looking at the opposite, “why you shouldn’t”.

Why You Should Use A Risk Questionnaire

1. To Better Understand Your Prospects And Clients, So You Can Recommend Great Investments 

There has been an explosion in psychological and economic research about decision making since the late 90’s, culminating in Daniel Kahneman winning the 2002 Nobel Prize In Economics. This research and others has taught us how people make decisions.

We’ve learnt that people suffer losses more than they enjoy gains or that people have a tendency to follow the crowd and chase returns. This was not widely documented 10 years ago. We can use this information to design a questionnaire that taps into what clients want, need and how they will react during a market correction. This data will help you build a winning investment approach for your clients.

Additionally, one study found that advisors who use traditional conversational interviews to assess risk tolerance are only 40% accurate. 60% of the time, advisors are wrong about their clients’ risk tolerance. As Michael Kitces, the well-known financial planning blogger stated “a well-designed RTQ [risk tolerance questionnaire] is actually far more effective than an advisor’s professional (but highly subjective and potentially-business-model-biased) judgment“.

2. Company Efficiency

Having a standardized process for prospecting, on-boarding new clients and completing annual reviews will save you and your company mountains of time. If your firm uses a paper based questionnaire then going online will make your life incredibly easier.

I was recently speaking to a Pocket Risk customer who said switching to a comprehensive online risk questionnaire saves her company at least a few thousand dollars a year in employee time, filling and mailing costs.

3. Risk Profiling Compliance

The compliance burden for advisors is only going one way. Up! Regulatory agencies in Canada and the UK have become increasingly prescriptive about the need to assess a client’s risk tolerance, risk capacity and goals. The US, Australia and India are not far behind. Furthermore, especially in the U.S., regulators have been increasingly fining firms and expelling individuals for suitability failures. Last year there were $18,300,000 in fines. With the new Department of Labor Fiduciary Rule, more are likely to come for those who fail to accurately assess their clients’ risk profile.

Why You Should Not Use A Risk Questionnaire

Since I considered the argument for using a risk questionnaire, lets consider the reverse. The most common reason for not using a risk questionnaire is fear of documentation.

If you are afraid of documenting your clients’ wishes then it must be because you’re worried facts might be misconstrued and used to file a complaint against your firm. That is a legitimate concern and a valid reason for not using a risk questionnaire. However, we believe the solution to this problem is not to leave a vacuum of information but to…

  1. Only work with clients who demonstrate integrity. Avoid litigious individuals. No matter the facts, certain types of people will always sue you if something goes wrong.
  2. Use documentation to protect you by ensuring there are no “grey areas” to be misconstrued. Get your clients to sign off on your decisions. A vacuum of information leaves more open to debate.
  3. Use tools and services that comply with the letter of the regulations and their spirit.

Conclusion

If a risk questionnaire is effective and compliant then all advisors should use them. Evidence shows that the conversational interviews to assess risk are wrong 60% of the time. So if you want to recommend the best possible investment approach for your prospects and clients, it makes sense to use a comprehensive risk profile questionnaire.