As an RIA or hybrid advisor, you likely know plenty about your clients. Still, you're probably overestimating how familiar you are with how they view risk. That's because many of you likely rely on platforms that claim to determine their overall risk profile, even as the reality is that the questions such platforms use to do that are unsound.
Too Basic
Today's risk tools are too basic, failing in many instances to account for the difference between risk tolerance (the point when potential portfolio losses become too stressful) and risk capacity (declines a client can withstand). The upshot is thousands of advisors across the country have no good way to determine the true risk profile of their clients.
Case in point, suppose a questionnaire asks a client to rate their risk tolerance on a scale of 1-10. Whatever their response is, it will reveal next to nothing about their risk capacity. True, as their advisor, you should know their age, job status, sources of income and expenses, dependents and beneficiaries, and how much money they have invested. Still, that may not be enough information.
What if they are considering starting a new business? Perhaps a loved one has a severe health concern. Their marital status could be about to change. Maybe they have legal problems. All these things could influence how much risk they can afford to take on.
The other issue? Let's say they rate themselves a six. Does that really mean anything? After all, one person's six could be your version of a four or even an eight.
A disconnect like that will cloud the portfolio construction process, affecting your view of which funds a client should own and how long they should own them based on market performance. Further, any lack of alignment could present a series of compliance and regulatory concerns.
More Detailed Questions, Mixed Results
But even when advisors move beyond crude risk assessment measures and ask more detailed questions, the results are still mixed.
For one, the framing of risk assessment questions can play an outsized role in the answers respondents provide. If you ask a client whether they are willing to absorb a loss of $500,000, the knee-jerk reaction could be, "Of course not." But if they have a net worth of $12 million, and you instead frame the question in terms of a percentage of their net worth, their answer may be different.
Another problem is the subjective way some platforms weigh questionnaire answers equally. That's a concern because some factors may be more influential than others in determining risk, even as they often get scored the same. Past research has demonstrated that assigning weights proportional to the factor's risk tolerance predictability is crucial to accurately determining an investor's risk profile.
Also, keep in mind that someone's social circle can play a huge role in how and whether they invest. For example, an academic paper found that when someone moves to a community where residents are invested in the stock market at a rate of at least 10%, they are much more likely to increase their equity exposure.
Similarly, studies have shown traumatic life experiences can significantly shape an individual's risk tolerance and influence investment decisions. Think of older generations who lived through high inflationary periods—especially in foreign countries—or even millennials who came of age during the financial crisis.
Yet, questions about social environment and life experience are nowhere to be found in the industry's most-used risk assessment tests.
Better for Everyone
Part of the solution to solving some of the above problems is research. Indeed, more platforms should be collaborating with academics from top universities to help advisors ask more relevant and better questions.
Whatever the case, better risk assessment processes benefit all the industry's stakeholders. They could produce improved investment outcomes for clients, allowing them to achieve more of their goals.
For advisors, the stakes are equally significant. More robust risk tools and processes could help you avoid the SEC’s ever-growing scrutiny of our industry. But more than that, they help narrow the disconnect that often exists today between your clients’ overall risk profile and your perception of it.
And if you can close that gap, it could yield a greater level of satisfaction across your book of business—which may mean higher retention rates, more referrals and additional assets under management.
Akhil Lodha is the CEO of StratiFi Technologies, a financial technology platform for wealth management enterprises and their financial advisors.
