By Mark Friedenthal
With the Department of Labor’s fiduciary rule partially in place, financial advisors are under more pressure than ever. Not only are they expected to act in their clients’ best interests, they must also demonstrate a full understanding of their clients’ financial wants and needs, as well as document and substantiate any advice provided on their behalf.
Coinciding with the intensifying spotlight on fiduciaries is the rise of financial technology dedicated to helping advisors serve their clients’ best interests. One tool that has come into the limelight is a new brand of risk tolerance assessment technology.
While risk tolerance assessments are nothing new, they’ve traditionally been viewed as a static, one-time survey or interview designed to pigeonhole the client into one of three silos: conservative, moderate or aggressive. However, these rudimentary systems do little to justify the financial advice offered to the client. Merely labeling a client as “moderate” after a 10-question personality quiz may not hold up in a post-fiduciary world where advisors are expected to go the extra mile in getting to know their clients, fully understand their financial pictures and provide holistic, tailored advice based on specific needs.
Under this new set of expectations, a rudimentary risk tolerance quiz designed to satisfy only the most basic level of compliance simply may not suffice. The next time there’s a market crash and litigation inevitably arises, advisors using outdated risk assessment systems are going to scramble to find specific evidence substantiating the advice they provided months or years prior.
So how can you tell if your risk tolerance assessments are up to snuff? Here are the three most common pitfalls when it comes to risk tolerance assessments today:
1. Not specific enough
The traditional model of plugging clients into one of three categories is dead. These titles (conservative, moderate or aggressive) are vague and offer the advisor little insight into the client’s motivations. Not to mention, changing from one bucket to another could come with dramatic implications for portfolio returns. If they happen to reduce their risk strategy during a market peak, it would obviously result in a very beneficial situation for the investor. However, if they switch to a more conservative bucket right after the market bottoms out, their returns could dramatically diminish.
2. Too focused on personality
Traditional risk tolerance assessments tend to focus too much on an investor’s personality, or their willingness to take on risk, as opposed to their actual ability to take risk. Simplified approaches typically aren’t customized for the investor’s specific confluence of chronological cash-flow assumptions, both in and out. If an investor has a limited ability to take on risk, their personality should not have much bearing on the risk profile of the portfolio. An approach that carefully balances both an investor’s willingness, as well as their ability, to take on risk will produce a much more favorable long-term result for the client.
3. No chronological evolution
Typically, financial advisors often don’t come back to update their clients’ risk tolerance information frequently, and there’s seldom any indication of how the investor’s risk tolerance evolves over time. However, an investor’s ability to take risk can evolve materially as they “move through” their cash-flows. In addition, new information presented over time warrants refreshing an analysis of their ability to take risk. Also, generally understanding the pace at which investment risk will likely evolve as an individual ages is extremely useful in deciding how and when to make portfolio adjustments and even how frequently to re-evaluate.
Mark Friedenthal is the founder of risk assessment tool Tolerisk.