While these questionnaires provide initial insight into a client’s financial goals, there is a major drawback to relying solely on them.
The issue with the majority of risk questionnaires is that their scopes are too narrow, focusing almost entirely on the client’s self-identified risk appetite, while completely neglecting their risk capacity. This approach is unfortunate and inadequate because risk capacity is a more concrete and reliable barometer for a client’s true financial state, which considers what type of deficit they would be able to bounce back from given their unique financial situation.
So, are current risk tolerance questionnaires truly necessary and effective? There are some benefits. While current versions may not be entirely useful in assessing risk, they can be helpful in getting an initial understanding of new clients.
However, with the assistance of technology solutions, advisors can utilize risk questionnaires that provide a more holistic overview of what their clients’ true risks are, and build portfolios that take several factors such as family, financial responsibility and where clients live into account to build a more tailored portfolio.
Appetite for Risk
Risk Appetite is incredibly difficult to extrapolate and pinpoint because of its inherently subjective nature. Since clients often have no idea what their appetites should be or how to answer hypothetical questions, they usually end up choosing something in the middle or what they think makes them look good, rendering the exercise moot. Similar to how most people portray to their doctor they’re a lot healthier and lead a better lifestyle than they actually do.
The other issue is varying definitions of what exactly is considered risky. What I think is moderate in risk, you might deem extremely risky. Similarly, it has been clearly documented and researched that individuals’ appetite for risk can change dramatically over time, driven by news or market sentiment.
When the market is going up, everyone’s appetite for risk is high and constantly reaching higher. It is only when the tables turn, and markets soften, that people truly begin to understand their appetite for risk. As current questionnaires are not aware of the clients existing risk exposures, needs and goals, the self-reported risk appetite can swing widely, be short-sighted and not help clients stay the course.
There is a vast and visceral difference between saying you are willing to see your portfolio down 20 percent and actually waking up to that reality one morning. While a theoretical loss is easier to swallow, until you are faced with the harsh reality of a major loss, you are not fully aware of what you can truly stomach. So, any questionnaire that pointblank asks a client what they are willing to lose is inherently doing the client a disservice and overestimating his risk appetite. Furthermore, the majority of questionnaires, while well-intentioned, are difficult for clients to thoughtfully answer.
While many clients will do research and educate themselves to be sure they understand how their money is being handled, there are some individuals that rely heavily on their advisors and turn a blind eye to their portfolios. Does the lay-person have enough financial knowledge to understand, digest and deliver an accurate and appropriate response?
Identifying Risk Capacity
Questionnaires and risk profiling tools need to begin to explore the long-neglected area of risk capacity, or the client’s ability to take risk given their unique Human Capital Factors. These factors, who the client is, his family, where he lives and works and what he’s trying to accomplish, need to be assessed and translated so this holistic picture can be matched with financial products that suit the client’s unique needs. For instance, women need to take into account their financial future and how becoming a mother may affect their finances and salary potential. Similarly, men living in Silicon Valley working in tech need to understand how their industry and where they live affects their investments and how they may need to avoid excess exposure to one sector: tech.
Will the generic paper questionnaire handed from advisor to client become irrelevant? Yes, they are already a cumbersome and archaic process that is used purely to check a box. However, with the appropriate questions and ability to identify risk, questionnaires could remain vital. A questionnaire as part of a thoughtful, holistic risk profiling approach, which is delivered or augmented through technology, is the way of the future.
We expect to see an increase in this approach as it is part of the natural progression in advisors adopting and leveraging tech to make their practices more efficient in the face of mounting headwinds and industry changes. With the assistance of tech and oversight from a financial advisor, clients will receive the optimal hybrid approach that ensures their portfolios are tailored to their true risk capacities, driven by unique human capital factors, as well as incorporating their risk appetites.
In the end, everyone wins. Advisors will have a more efficient, but deeper, understanding of their clients, leading to faster conversion and stickier relationships. Clients will receive more bespoke and appropriate advice with a keen appreciation of what their advisors are trying to accomplish.
Min Zhang is CEO and co-founder of Totum Wealth.