Using questionnaires to determine an investment strategy is often frowned upon by both local and international regulators. As Paul Resnik explains, financial advisers will have to find other ways to ensure their clients are given the best advice possible.
Until recently, it had been quite common for advisers to arrive at an investment strategy in a single step using a 'portfolio picker’ questionnaire which addressed goals, time horizon, risk capacity and risk tolerance in as little as eight to 10 questions.
This practice has become increasingly unacceptable in Australia and in other countries where portfolio recommendations are made to retail investors. In the UK, the regulator has condemned such tests as failing to recognise the individual needs of clients. So what are the options now available to the conscientious financial adviser keen to ensure clients are given true best advice?
For expert and professional advice, advisers need to make separate assessments of risk required, risk capacity and risk tolerance so that mismatches can be identified, differences reconciled and the level of risk taken on in the portfolio agreed by the client.
The financial planner and the client share a common interest: neither one wants the relationship to end unhappily. And the most likely cause of an abrupt, unhappy ending is mismanaged risk.
In difficult markets, what was previously thought of as a “risk” becomes a reality. This may trigger, at best, simple dissatisfaction. At its worst, it could trigger a crisis of confidence in the planner’s competence, a formal complaint, legal action and even eventually loss of capacity to advise.
The actual impact of the risk will depend on the client’s risk tolerance and expectations. Is the client’s investment strategy consistent with his or her risk tolerance, and does the client understand the risks? Has the client made an informed decision to accept the risks in the investment recommendation and the plan?
Of course, there is more to managing risk than risk tolerance and expectations. Planners talk to clients all the time about risk issues, while compliance departments dedicate an enormous percentage of their time to the risk-related aspects of advice.
Yet even with all the ostensible focus on risk, many planners do not handle the risk conversation well. And sometimes this may be because they, themselves, are not clear as to the finer points.
Risk has three primary aspects:
- Risk required – the risk associated with the return that would be required to achieve the client’s goals (a financial characteristic).
- Risk capacity – the extent to which the future can be less favourable than predicted without derailing the client’s plans (a financial characteristic).
- Risk tolerance – the level of risk the client prefers to take (a personality characteristic).
Risk required
How can risk be required? Strictly, it’s not risk that’s required. Planning software determines the return required to achieve goals and there will be a level of risk associated with that return. Hence, a risk is required.
Of course, the first time the inputs are fed through the planning software, the return required might be impossibly high – eg, inflation plus 20 per cent. In this case, some reality checking and goal reviews will be needed to bring the return down to a level that is at least feasible.
Risk capacity
Risk capacity is the extent to which an individual’s financial plan can withstand the impact of negative events.
While ‘risk required’ means a return that is expected to achieve the client’s goals, what happens if the actual return falls short of the expected return? What if the client lives longer or living costs are higher than expected?
Clearly, unexpected negative outcomes might derail the client’s plan, which means that the plan must be stress-tested and that will involve Monte Carlo modelling or some other form of stochastic testing.
Monte Carlo modelling
Monte Carlo modelling will estimate the likelihood of achieving any particular goal. If investment returns were the only variable, then the risk/return required would be expected to deliver the desired goals 50 per cent of the time, provided the distribution of investment returns is symmetrical.
Let’s suppose that there is only a single goal – an income stream in retirement – and investment returns are the only variable.
Monte Carlo modelling will estimate the likelihood of achieving the goal. If the likelihood is 50 per cent, then the plan has no risk capacity because any underperformance by the investments will result in the goal not being achieved.
It is important to note that in both an accumulation scenario and a decumulation scenario, it is not just the average return (arithmetic or geometric) that determines performance, but rather the dollar-weighted return.
With any investment strategy there will be ‘good’ years and ‘bad’ years. In an accumulation scenario, you hope the ‘good’ years occur at the end and in a decumulation scenario at the beginning.
For a goal as important as income-in-retirement, a 50 per cent chance of success is unlikely to be acceptable, which means that trade-offs will be required.
Trade-offs can only be made between those variables over which the client has control. This includes the level of savings and the targets for retirement date, income-in-retirement, and investment return.
Saving more, retiring later, reducing the income-in-retirement target, and/or taking more investment risk will increase the likelihood of achieving the income-in-retirement target.
Risk tolerance
Risk tolerance is the level of risk the client would prefer to take. It is a psychological construct.
Because financial advisers are on average significantly more risk tolerant than their clients, the temptation is for an adviser to recommend a level of risk that the adviser would be comfortable with, particularly as all the evidence shows that advisers do not have accurate understandings of their clients’ risk tolerance.
However, occasionally a client who has moderate goals in relation to the resources available will find that risk required is (significantly) less than risk tolerance, in which case taking the risk required might be taking too little risk, in that the client will miss out on opportunities that they could have taken comfortably.
Where a client’s risk tolerance is less than the risk in the investment strategy determined through Monte Carlo modelling, the client has a problem. In fact, most clients have this problem.
The problem could be solved through taking more risk than they would prefer, but risk tolerance can only be stretched so far. Other solutions, such as saving more, converting personal use assets to investment assets, and lowering, deferring, or foregoing goals should also be considered.
Managing risk equals reward
Managing risk requires understanding and skill, but it is not rocket science. With the appropriate tools, planners can identify the three ingredients and examine their interaction so that mismatches can be resolved openly on the basis of what is important to the client and with the client’s full understanding. The bottom line is to have the client give his or her properly informed commitment to the riskiness of the recommended portfolio.
Dealing with risk professionally will result in better advice and more quickly build the trust necessary for good client relationships. Clients don’t have to be persuaded that risk is an important issue. The more planners can demonstrate the three aspects of risk are being dealt with appropriately, the more client relationships will improve.
Paul Resnik is the co-founder and director of FinaMetrica.
