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Revisiting Client Risk Profiling: a 3D View

The last few months have seen some uncomfortable conversations between advisors and their clients. Twitchy markets unsettle even seasoned veterans, and advisors are earning their keep by focusing on the behavioral tendencies of many to take the wrong action at the wrong time. “Stay the course” remains sound strategy, assuming that the course was set with a thorough understanding of the client’s needs, preferences, and resources. 

Part of developing that deep understanding of the client to guide investment strategy rests with client risk profiling. Risk profiling has evolved from advisors applying intuition about clients to a compliance-driven, defensive documentation exercise to a business development strategy where client inputs invite initial discussions with advisors about potential disconnects between their risk tolerance and portfolio structure.

Despite this evolution, it seems that intuition still dominates the risk profiling process, with results that are sometimes less than optimal. For example, Amy Hubble and John Grable conducted a study of 200 advisors (The Efficient Frontuzzle: What Investment Risk Profiling Still Fails To Solve) that revealed that advisors interpreted and incorporated very relevant information about a set of hypothetical investors very inconsistently, so that prospective clients meeting with several prospective advisors would get rather different recommended portfolio designs.

Indeed, Hubble and Grable noted the tendency for advisors to apparently gravitate towards a simple rule of thumb relating age to risk assets (essentially, subtracting the client’s age from 1 to arrive at the equity component of the recommended portfolio structure.)  While the client’s age is certainly relevant, it is far from the whole client risk profile story.

Part of the problem is a lack of consistency and understanding around the vocabulary. “Risk tolerance” is a very textured concept that is ultimately described by a mix of behavioral, quantitative, and qualitative factors. As tempting as it may be to reduce a client risk profile to a single “risk score,” there is a lot of room for missing important factors that may not lend themselves as easily to a single score.

To help advisors understand the full range of factors that go into describing client risk tolerance, I joined Hubble and Grable in publishing “Investment Risk Profiling: A Guide For Financial Advisors.” The Guide describes advisor best practices focused on three essential dimensions of client risk profiling: Risk Need, Risk-Taking Ability, and Behavioral Loss Tolerance. 

Risk Need is perhaps the easiest dimension to consider, since it is at the heart of any financial plan. Given the client’s current assets, future cashflows expected due to earnings, savings, or other sources, and the future goals that the client needs or wants to fund, the advisor can do some easy calculations to determine what rate of return is required over a planning horizon.  And, given the advisor’s judgment of expectations for market returns, she can then advise the client with confidence as to whether a portfolio can be designed to deliver the required return, or whether some retooling of the basic parameters is needed (cutting back on future goals, or extending cash flows by working longer, etc.)

Risk-Taking Ability is the second dimension of client risk profiling and is one that often is not emphasized enough. Simply put, if a client cannot weather market turns without suffering serious disruptions to their goals, they have little capacity for taking risk.  The client who is depending on their portfolio to propel them to a desired standard of living from one that barely addresses what they consider bare necessities is especially likely to have little capacity for risk, since poor market performance at the wrong time can not only put desired goals out of reach but also endanger a baseline standard of living. In contrast, clients with additional pension income or high-probability inheritances generally have more capacity for portfolio risk.

Risk-taking ability can vary over the course of clients’ lives, and so it is essential that it be explicitly reconsidered from time to time. “One and done” risk profiling might work for compliance purposes, but is less suitable for informing ongoing portfolio strategy. 

Behavioral Loss Tolerance is the third dimension of risk profiling, and is probably the dimension advisors are least well suited to assessing on their own. The research suggests that there are six elements to behavioral loss tolerance that should be assessed independently: risk tolerance, risk preference, financial knowledge, investing experience, risk perception, and risk composure.

Many commercial risk profiling products help advisors assess at least some of these elements, and the market tumult in 2020 during the pandemic offers advisors many fresh insights as to their clients’ behavioral tendencies.  Advisors should “look under the hood” of commercial questionnaires to assure themselves that the tools are valid (i.e. that they actually measure the attribute of interest) and reliable (i.e. that they produce similar results for the same person in multiple administrations).  Our paper offers tips and red flags for advisors to consider, because we believe that relying on a faulty or partial assessment of behavioral loss tolerance can skew advisors’ understanding of their client’s risk profile. 

Having considered the three dimensions of risk profiling, advisors aren’t quite done: each dimension offers its own signal about client risk, and advisors need to apply professional judgment to reconcile the three dimensions. Often, risk-taking ability is the limiting factor that will dominate. The advisor’s judgment is especially important around behavioral risk tolerance, to decide whether that need limit an investment solution or if clients can be productively coached to a solution in keeping with risk need and risk-taking ability. 

Those uneasy conversations between advisors and clients about recent market shocks can be a lead in to conversations that more fully explore the three dimensions of client risk profiling, and productive client conversations about how the portfolio design relates to their specific needs and tolerances. Reminding clients about how you have accounted for risk builds confidence and can reassure them in these troubling times.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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