Aligning your client’s expectations with their tolerance for risk is a top priority in the financial advising business, yet we often scoff at risk profile questionnaires.
In speaking with 719 advisors last year, I found that risk questionnaires are often used improperly. This is because most risk questionnaires do not differentiate between a person’s willingness to take risk, his view and how he feels about risk.
The Financial Industry Regulatory Authority’s (FINRA) new rule 2111 seems to be triggering serious discussion about advice suitability in regards to risk. For the first time, we are seeing segregation between risk tolerance and risk capacity.
Evaluating risk is really a three-part process that is broken down into risk capacity, risk perception and risk tolerance. The process needs some way to measure or quantify one’s risk. Two questions to ask are:
- What have you invested in the past?
- At what level of decline in the market do you become uncomfortable? (Note: It is good to ask this question in percentage terms and also in dollar terms relative to the size of your client’s portfolio).
From there, we need to look at the three components: risk capacity – willingness to take risk; risk perception – how risky you think an investment is; and risk tolerance – how you feel about taking risk.
Above the Rest
I have used FinaMetrica for eight years. It offers a questionnaire that does two things:
FinaMetrica has done a great job in measuring the two points above: 1. Ties answers to historical performance; and 2. Breaks the question of risk into three parts. This is because they have analyzed the specific wording that is used and have systematically compared results to market action.
But relying on FinaMetrica alone is not enough. It takes a serious advisor to have a discussion about risk with a client. As a sales trainer for financial advisors, I teach not just to use a risk profile but to use it as a sales tool and a way of prompting an expectations-related conversation.
In an article written on August 28, 2013 on ThinkAdvisor.com, Geoff Davey, one of the founders of FinaMetrica, states, regarding FINRAs mixed message between compliance and suitability about risk tolerance, “It is indicative of the terminology difficulties that abound in discussions about risk tolerance specifically and risk suitability generally.”
This may become more tumultuous with FINRA’s rule 2111. FINRA defines risk tolerance as “a customer’s ability and willingness to lose some or all of the original investment in exchange for greater potential returns.”
The problem with this definition is that it is a statement of the accepted belief that young investors are more capable of recovering from a setback because they have more years to invest until retirement; however, the rule is about one’s personal finances and not psychological predisposition.
The fact of the matter is that we need a way to measure the three components of risk: capacity, perception and tolerance, and then have a discussion with clients in order to most effectively meet their expectations.
Since 2009, the market has treated advisors fairly with a smooth glide path. However, if history is any indication of the future, the smooth glide path may tumble into a market sequence risk. This will certainly prompt a much more serious conversation about risk-taking.