Gauging how much risk a client is willing to take is not an easy task. instead, it is a moving target that some professionals compare to diagnosing an illness of a baby or a pet that cannot tell you how they are feeling.
You may be surprised to learn that frequently clients don't really understand how much risk they are currently taking or willing to take until they are in the middle of volatile times. It is common to see portfolios that are way off the mark and completely out of sync with a particular client's tolerance for risk.
The traditional measurement method used by investment firms is a client risk tolerance questionnaire. This survey is just the beginning, but an important first step nonetheless. The questions represent a combination of factual answers followed by some judgmental questions. The important facts are quantitative in nature, such as age, composition of asset base, and a summary of income and expenses.
WEIGHING THE FACTORS
Age is a significant factor because it gives you some context for the desired outcomes. Obviously an older client has far less time to tolerate losses than a younger client. And unlike an institution, an older client, who may be retired, cannot simply earn additional money and add to their portfolio to compensate for losses. It also allows you to frame up the time horizon from the perspective of life expectancy.
Composition of asset base matters from the perspective of income, liquidity and marketability. Say, for example, that your client has significant holdings in raw land. While this asset may have substantial value, it is not income-generating and may even cause negative cash flow for taxes and other possible maintenance issues. Similarly, this raw land is not liquid, and would likely take time to convert into cash. It could also require further investment from the client to get the land ready for sale. There may also be several other factors that limit the marketability of this land. Is the land free and clear of all encumbrances, and specifically any environmental encumbrances? How about title? Does your client have a clear, marketable title, or is the asset in an entity with partners or other additional restrictions or roadblocks that may prevent a sale?
Your client's day-to-day sources and uses of cash are another material factor. Will they need income from their portfolio or are cash flow needs met from other sources? In today's low-rate environment, constructing a portfolio for income may consume a higher percentage of their assets than in prior years, and possibly cause a slowdown in overall growth. And you must assess the possible outcomes of slow growth and your client's ability to keep pace with inflation.
After carefully evaluating the quantitative factors, the planner will be able to come up with some conclusions regarding how much a client would need to earn on assets to meet all of their life goals and dreams. The questionnaire allows you a glimpse into what the client feels about risk. This quantitative analysis will direct you on how much risk may be necessary in order to attain the desired returns.
In some cases, it is plainly clear that a client has more income and assets than they require. In this case, risk tolerance is still important, but primarily from the perspective of allowing the client to understand that the investment outcomes are not the key driver to sustainable financial independence. When the opposite set of facts are prevalent, and your client appears to be under-funded for financial independence, they need to know that seeking higher rates of return will mean that their assets are subjected to greater risk, and therefore greater volatility. If your risk tolerance questioning indicates a deep discomfort with volatility and risk, it would be the job of the planner to suggest alternatives. These alternatives could include reduced spending, working longer, relocating to a less costly home or taking more portfolio risk.
RISK AND EMOTION
A client's tolerance for risk is a bit like the weather. When the weather is great, people love where they live. When the weather is lousy, people want to be somewhere else. This relates to risk tolerance by looking at client attitudes about equity investing and real estate investing. Before the last real estate bubble, everyone wanted to own real estate. People were quitting their jobs to hop on flights to Florida, Arizona or California to buy real estate. They were confident that what they bought would continue to appreciate and create handsome profits. But when that bubble began to deflate in 2008, there were no buyers to be found for anything. Where were all these risk-takers when auctions were more common than traditional sales, and homes could be bought for 50 percent or less than their previous sale price?
The same thing happened during the equity market collapse of 2008. People ran from the markets so fast that some haven't stopped to look back. And, of course, while they were running, equity markets in the U. S. have more than doubled. While demand has not exactly soared for equities, some are now wondering if it is time for them to take on more risk with their savings. Our job is to stick to the facts, and not let client emotions and headlines about markets drive their appetite for risk.
Beyond the facts and circumstances, gauging a client's tolerance for risk is a combination of art and science that lives with you every day of the client relationship. The core of this effort rests with your client relationship. The advisors need to know the client very well. You need to know about their personal life, what is important to them and how they like to spend their time. This can only be done by asking the appropriate questions and spending time with your clients.
Many surveys show that the No. 1 reason that clients change advisors is because of poor communications. Clients simply do not hear from their advisors enough. The best advisors are proactive when it comes to client communications - especially during volatile times with their portfolios. Don't wait for your client to call you to ask what you plan to do during volatile times - call them and tell them what you plan to do and ask if there is anything else that they'd like you to consider. It would be wise to anticipate their questions, and have some answers ready. The easy and obvious question will be the consequences of the volatility on their plan. Prior to the call, it may be a good idea to have a new forecast available to be able to speak intelligently about the consequences of the volatility.
This process of gauging and managing your client's tolerance for risk is important and has serious consequences. The last place you ever want to be is defending your position in the face of a client or their heirs who feel that you misrepresented the client. Document all of your interactions, communications and meetings to show that you were attentive to the client's feelings and needs, and that you acted in good faith and in the best interest of your client.
WORK WITH VOLATILITY
A method of dealing with risk tolerance is to incorporate volatility management into your asset management process. Rather than a simple asset allocation, where the advisor may try to mirror or out-perform a given index, consider managing the portfolio to a desired level of volatility. The objective here would be to smooth out the ups and downs of the portfolio and the benchmark indices.
A strategy focused on volatility management may expect to lag an index during bullish times, but give you better odds at outperforming during bad times. Clients that are approaching retirement or already retired may like the idea of eliminating "fat tails" in a portfolio. As long as you set the expectation of the client and clearly communicate to your client about the possible outcomes, and then deliver within that range of expectations, client misunderstandings should be fewer.
Volatility management is a quantitative, sophisticated method of managing money. But since the last market meltdown, we are seeing growth for managers utilizing this style of asset management versus the low-expense indexers. The tools and knowledge needed to manage volatility on a daily basis may be too much for the average investment advisor, and possibly out of reach for the smaller do-it-yourself investment management RIA. Seek out sub-advisors or separate account managers for assistance with portfolios focused on volatility management.
Volatility is a two-way street. It isn't only about losing money. When markets are in a full bull-appreciation sprint, volatility may also be high. No one knows for sure when it is appropriate to turn up or dial down the risk in a portfolio. But as professionals, we are supposed to stay within the limits prescribed by the client or as discovered in your financial planning process. So when your conservative client calls tomorrow and asks if their portfolio should be more risky, the answer should always be grounded in their long-term needs and attitude about risk, unadjusted for headline news.
John P. Napolitano, CFP, CPA, PFS, MST, is CEO of U.S. Wealth Management in Brain-tree, Mass. Reach him at (781) 849-9200.
