For years, advisors at financial institutions have relied heavily on risk tolerance questionnaires as a method to profile their clients. The answers are weighted and scored to derive what is considered to be an appropriate investment objective and corresponding asset allocation.
During the advisory process, risk tolerance questionnaires often are established at the firm level and utilized with every new client and as an integral part of the client’s annual or semi-annual review meeting. Questionnaires may vary firm to firm, but generally attempt to identify the client’s risk tolerance through an average of 10 to 15 questions. The process may be manual on a piece of paper or entered into software to determine the results. Either way, the process is considered to be an essential element for compliance purposes.
While the risk tolerance questionnaire seems reasonable for having a consistent approach across the firm, recent market events beg the question of whether advisors are asking clients the “right” questions to truly ascertain their investment goals. Instead of asking “what is your investment return objective,” advisors should really ask, “how much loss can you withstand in your portfolio?” It is true that there are more sophisticated risk tolerance questionnaires that could be brought into the mix here, but there is a balancing act between having a solid understanding of a client’s risk tolerance and creating a process for advisors that is so time consuming that they bypass the true purpose of the questionnaire. Investors are seeking personalized discussions with their advisors more than ever before.
Understanding a client’s loss experience threshold is a valuable conversation that advisors should have with their clients. With the proposed regulations, every aspect of the advisory process will be reviewed, making this the optimal time to shift the paradigm from risk tolerance to loss management.
What do you think? We are interested to hear if you think firms will actually embrace more of a “loss experience” focus with their clients in the future.