Advisors have traditionally used risk tolerance questionnaires and basic timelines as the basis for portfolio recommendations. Unfortunately, these practices are riddled with flaws. As outlined below, including and prioritizing risk capacity offers a far superior method in advising clients with their investments.
The Pitfalls of Risk Tolerance Questionnaires
Risk tolerance, or preference, is based on a client’s comfort level to withstand losses. This methodology has traditionally been based on how the client feels about potential losses in their investments, and measured on an arbitrary scale from low risk, or “conservative,” to high risk, or “aggressive.”
Basing recommendations solely on the client’s feelings, and using a scale that is in itself subjective, results in portfolios that are misaligned with clients’ needs.
Bias and Subjectivity
The major pitfall of using a traditional risk tolerance questionnaire is its subjective nature. As we covered in our article, “Why Traditional Risk Tolerance Questionnaires Lead to Inaccurate Risk Appetite,” clients can have unconscious biases that affect their feelings about investments. Some of these biases are ingrained, while others are reflective of current circumstances. A down market, for example, can prompt investors to overreact and adversely affect their long-term financial goals.
Financial author, advisor, and WealthTech influencer Michael Kitces addresses this concern in his article “The Sorry State of Risk Tolerance Questionnaires for Advisors.” Kitces covers one of the key shortcomings of using these traditional questionnaires, which relies on the client’s risk perception—their perceived view of risk regarding an investment, whether it’s accurate or not. These perceptions can become misperceptions and can impact how an investor reacts to certain events.
Author Karin Maloney supports this statement in her MarketWatch article “Making Better Investment Decisions.” She wrote, “Three things undermine the relevance of risk tolerance in asset allocation decisions: Emotions are subject to change, we don’t always know what we don’t know, and there is a classic human disconnect between what we say and what we do when emotions like fear and greed take over.”
Additionally, clients’ responses can swing widely from day-to-day, depending on how they feel about other issues—from their comfort level with you, the advisor, to personal problems, and beyond.
Considering the average client has little to no investment experience, asking him or her to make an arbitrary financial assessment—particularly one riddled with bias and subjectivity—seems unreasonable.
Lack of Quantification
In the same article, Kitces also explains another key pitfall of using online risk tolerance questionnaires, which is the inability to quantify the answers. He states, “In addition, the reality is that it’s difficult to measure the subjective aspects of risk tolerance itself, simply because it’s the representation of an abstract psychological trait in the first place.”
In examining the traditional scale of the “conservative,” “moderate,” and “aggressive,” we can see a lack of quantifiable data. Although these words do carry certain connotations, since they are biased and exist on an arbitrary scale, they cannot be exactly quantified.
Besides bias from the client, these phrases are prone to subjectivity from the advisor or firm as well. What one advisor or firm may view as “risky,” another may view as “moderate” or even “conservative.”
With bias happening on both ends, recommendations can be skewed to the point of complete misalignment.
Totum’s risk ban calculates and compares 3 risk scores- risk capacity, risk preference, and portfolio risk to give advisors a more robust view of an individual’s willingness AND ability to take on risk.
Compliance and Underwhelming Results
These numerous shortcomings are further exacerbated when a financial risk tolerance questionnaire is used as the sole basis when building a client’s portfolio.
When you can’t quantify the information a client provides to you, and the majority of the information you do collect is based on biases and subjective feelings, matching a portfolio to their needs becomes more random. This can ultimately lead to underwhelming results and dissatisfied customers.
This dissatisfaction can lead to compliance issues. With the recent Regulation Best Interest (Reg BI) passed by the SEC, advisors are under more pressure than ever to act in the best interest of their clients. Since risk tolerance questionnaires for advisors are built on feelings, biases, and opinions, proving recommendations were in their best interest could be challenging.
Advisors must also consider FINRA’s suitability obligations. Otherwise known as Rule 2111, it “requires that a firm or associated person have a reasonable basis to believe a recommended transaction or investment strategy involving a security or securities is suitable for the customer.”
The remedy to dissatisfied customers and compliance issues is to focus on risk capacity.
Why Advisors Should Prioritize Risk Capacity
Risk capacity measures clients’ true abilities to take on risk-based on their life factors. While familiarizing yourself with a client’s risk tolerance has merit, prioritizing risk capacity can produce better results.
In his article “The Importance of Knowing Your Risk Capacity,” financial planner Steven Clark concurs. In an article addressed to retail customers, he wrote, “Although they are both important in determining how much risk you should be taking in your portfolio, I believe risk capacity should be the main determining factor followed by risk tolerance.”
A proper risk capacity assessment is based on factual data. It’s objective rather than subjective. It can also be quantified. These traits can improve results for your clients. It can also help you meet compliance obligations, which can protect your firm from arbitration.
The Quantifying Factors of Risk Capacity
Unlike risk tolerance, risk capacity is objective and based on facts. Answers are numerical facts and can, therefore, be quantified. Since these life factors are based on numbers, it becomes easier to identify actual investment needs.
While most traditional client risk tolerance questionnaires would include an investment time horizon, basing recommendations on this one fact alone is grossly incomplete.
In order to properly quantify a client’s true ability to take on risk, a thorough and complete assessment needs to take place. This is where a quality risk capacity questionnaire can be used.
Better Questions Lead to Improved Results
A proper risk capacity questionnaire takes into account myriad life factors that influence investment needs.
Our questionnaire, for example, asks clients the following questions:
- Annual income
- Assets to Invest
- Investment Time Horizon
- Household Size
- Zip Code
- Household Health
- Consistency of Earnings
- Stability of Employment
As you can see, investment time horizon is still included but isn’t the only factor used to calculate risk capacity. Instead, we’ve provided a comprehensive list of questions that can affect a client’s risk capacity and overall investment needs.
Knowing a client’s zip code, for example, allows our platform to calculate cost of living, while household health can greatly influence future income and liquidity needs.
A proper risk capacity questionnaire should also be adaptable. On average, a person experiences at least one life event a year that impacts their investment goals. Our platform allows for an annual review so that, as clients’ life factors change, their portfolios can be adjusted.
Over time, this fact-based flexibility can produce better results for your customers and improve the relationships you have with them.
Totum’s questionnaire can be designed to be as short as 9 simple questions most individuals complete in 3 minutes or less. The results are then archived for record-keeping and comparison.
Risk Capacity Assists with Compliance
Assessing clients’ risk capacity can also assist with Reg BI compliance, as discussed in our article “How a Proper Risk Capacity Score Helps Broker-Dealers Meet Reg BI Requirements.” Additionally, it helps satisfy FINRA’s suitability obligations. Since risk capacity is based on the client’s individual life factors, an advisor is much more likely to be able to prove that he or she acted in the client’s best interest.
This added protection can help protect an advisor against costly fines and arbitration. In 2020, there were 3,902 cases filed against advisors. Violations of FINRA and SEC regulations can be pricey, with filing fees alone starting at $2,200.
Totum Risk’s Multidimensional Platform
The Totum Risk platform goes beyond other platforms by separating risk capacity, risk preference, and the risk within a portfolio. While our risk profiling questionnaire does include psychological risk preferences, the majority of our questions are fact-based.
Our platform calculates three different risk scores: risk preference, risk capacity, and portfolio risk. These three scores provide far better insight than using risk tolerance alone.
In addition to the information provided by clients, our platform uses data mining and machine learning to complete the picture. The addition of this advanced AI into our platform allows us to ask fewer questions, yet produce more accurate risk scores. The questionnaire consists of 9 to 11 questions and is often completed in less than ten minutes.
Other features and benefits include:
- Saved, archived, and time-stamped processes
- Holistic and data-driven risk calculations
- An admin panel to track team activity and manage firm data
- Customized proposals to showcase your brand
- Mobile and desktop-friendly versions
- Availability as a link for websites, newsletters, and email signature
- FINRA-reviewed investment policy statements
- A platform provided by a listed FINRA compliance vendor
- Coverage of the SEC’s Regulation Best Interest rule.
Our complete portfolio risk assessment tool is objective, stable, and relevant. We believe that while risk tolerance is important, risk capacity produces better portfolio-matching for clients, as well as compliance protection.
Contact us today to schedule your free demo.
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