Markets turn volatile and a client who is normally calm panics. Or perhaps a self-described “risk-adverse” client grumbles that their returns should have been larger. These are just a couple of familiar scenes for many RIAs.
How do these situations happen? After all, most RIAs ask clients to fill out lengthy risk-tolerance questionnaires specifically designed to avoid this. By asking clients questions like, “If the market were to decline 30% or more, how would you react?” advisors measure how much volatility a client can stomach and build a portfolio to match. Or so they think.
The problem isn’t the client, though, and it’s probably not even the portfolio. The problem is likely your questionnaire, Meir Statman, professor of finance at Santa Clara University and author of “Finance for Normal People,” told Capital Group.
“Most (risk-tolerance) questionnaires are really trite” and don’t measure what’s important when building portfolios, Statman says. Most questionnaires measure how much volatility clients think they can accept, and miss much more important factors such as exuberance, regret and overconfidence. Fewer questionnaires, still, get at clients’ true goals. Advisors need to “have a better sense of what risk is,” he adds. And that’s not volatility.
Client questionnaire 2.0
Research suggesting client questionnaires are flawed holds existential questions for RIAs. Here’s why: The pseudo-precision of measuring clients’ perception of volatility is the fundamental starting point of many firms’ asset allocation process.
Luckily, there may be ways to vastly improve the questionnaire using behavioral finance. Meanwhile, some RIA firms are already retooling the process so conversations move away from “How’s my portfolio doing compared with the market?” to “How am I progressing toward my goals?”
What’s at stake
Questionnaires could create big blind spots for RIAs, who falsely feel that they know what clients expect. Once the nearly decade-long bull market ends, clients’ true beliefs might become known. Already, clients cite advisors’ lack of understanding of their risk tolerance as the sixth-most frequent reason to leave their advisor out of 16 variables asked about, says Spectrem Group. Some other reasons cited are indirectly related to not connecting goals with portfolios, such as “underperforming compared to the overall stock market.”
Understanding risk is important to clients.
Reasons clients change advisors (more than one choice could be selected)
Source: Spectrem Group, 2018
Steps to a better questionnaire
There are telltale signs your questionnaire isn’t truly measuring your clients’ risk tolerance. If you’re hearing from clients panicking when the market posts a big swing or that their friends’ portfolios are “doing better,” these might be signs your questionnaire could be improved, Statman says.
Statman outlines three steps to improve your client questionnaire:
Step 1: Decide if you want to measure risk tolerance in the questionnaire.
For some advisors, the questionnaire is really just a “protection against lawsuits,” Statman says. Some advisors are asking questions to inoculate themselves against challenges later. If a client indicates that they’re an aggressive investor and the market declines 20%, the advisor can point to the client’s signature on the form, Statman says. Some items on many questionnaires are more like legal disclosures than requests for the client’s opinion.
For example, many questionnaires contain statements like, “Foreign investments involve risks that are in addition to those of U.S. investments, including political and economic risks, as well as the risk of currency fluctuations.” But in reality foreign stocks can help reduce risk in a portfolio by adding non-U.S. economic exposure, Statman says.
Retooling a questionnaire requires advisors to move away from using them as a liability-controlling tool to one that helps clients.
In the case of international investing, Statman suggests replacing the disclosure with education, like, “Over time, international markets and asset classes within those markets have not always moved in unison with the U.S. market. U.S. stocks have outperformed international stocks during some periods, and international stocks have outperformed U.S. stocks during other periods. Investing a portion of a portfolio in international stocks and bonds reduces risk.”
With that understanding, you might ask the client, “Which statement best reflects your view on international investing?” and then ask the client to rate if they are very comfortable or uneasy with investing outside the U.S.
Step 2: Measure what really matters: goals, not volatility.
The idea that risk and volatility are synonymous is prevalent among advisors. But confusing the two very different concepts leaves advisors frustrated and clients disappointed, Statman says. Risk isn’t a client’s appetite for volatility, but rather the odds of not reaching their goals.
Statman cites the example of a client who is completely invested in short-term Treasuries notes. Certainly, the volatility of the portfolio would be low. But the risk the client faces is actually very high, as the portfolio will likely not generate returns to meet wants and goals.
Statman encourages advisors to review their questionnaires and instead find ways to gauge factors that are more important than volatility, such as:
Step 3: Customize the questionnaire based on net worth, and focus on goals.
The cookie-cutter nature of questionnaires can limit their effectiveness, especially with high net worth clients. For example, many questionnaires ask something like, “Would you want to make an investment where you have a 50-50 chance for a $3,639 loss or a $4,229 gain?” Statman says.
But this question is flawed in several ways. For one, it urges investors to focus solely on investment results in isolation, paying no attention to the goal of the investment. More importantly, though, the question doesn’t factor in the fact that a person willing to lose $3,639 on a $10,000 portfolio isn’t willing to lose the same percentage on a $5 million portfolio.
Statman suggests rephrasing this question away from dollar values and toward changes in standards of living, to something like: “Suppose you are given an opportunity to replace your current investment portfolio with a new portfolio. The new portfolio has a 50-50 chance of increasing your standard of living by 50% during your lifetime. However, it also has a 50-50 chance of reducing your standard of living by X% during your lifetime. What is the maximum X% reduction in standard of living you are willing to accept?”
Clients’ responses can be very useful in putting their risk tolerance in perspective with goals. As a benchmark, Statman found that on average, U.S. investors will tolerate a 12.6% reduction in their standard of living for a 50-50 chance at a 50% increase.
A better way? A case study
Some progressive RIAs, seeing the shortfalls in traditional questionnaires, are already retooling the process and looking for a better way.
WMBC, a Lake Forest, Calif.-based RIA with more than $100 million under management (60% in high net worth), for years gave clients a paper “Financial Planning Questionnaire” that asked standard questions. Those questions included asking about how clients would feel about their portfolios dropping in value, their investment time horizon and their past experiences with investment products. Advisors would use those questions to put an investor in, say, a “moderate” portfolio.
Over the years, WMBC realized the firm was doing more than just building portfolios and “those areas we focused on gave the clients much more satisfaction than their rate of return,” says David Coles, chief operating officer of WMBC. “We realized that we needed to create a process that brought these areas to the forefront of our work with the client and shift their mindset and ours to a broader view of their wealth.”
So while the questionnaire gave WMBC advisors insight into the clients’ feelings on market fluctuations, it didn’t explain the “why” driving the answers, Coles says. “Why could they only stomach a 10% loss? What other factors did they take into account when determining that answer?” he says.
So this year, WMBC along with behavioral professionals created a new questionnaire that addressed the client’s entire personal situation and even goes beyond money. The questionnaire probes clients’ emotions, health, external conditions and personal resources.
Questions are very different from what’s asked on a traditional questionnaire. It asks things like, “How much time spent discussing wealth with your family is stressful?” and “How much of the time do you find your job interesting?” Clients then answer questions on a Likert scale of one to 10.
After the client ranks their feelings toward the various topics, the firm summarizes the results for each aspect of wealth and life. “These scores are reviewed with the client to identify opportunities for change and offer direction to the advisor as to what financial system will bring about the client’s desired changes, not just the volatility range they think they want,” Coles says.
WMBC hopes to build out the system and make it available to other RIAs.
More advisors who follow suit and upgrade questionnaires so portfolios can be built to address goals, not just control for volatility, will likely find more satisfaction with clients, Statman says.
“The question really is, ‘What matters to you?’ These kinds of things will really guide you to the portfolios, not people’s attitudes towards risk,” Statman says. “Risk is like one of the cars of a train, but it’s not the engine of the train. The engine of the train is your aspirations.”
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.
All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.
Use of this website is intended for U.S. residents only.
American Funds Distributors, Inc., member FINRA.
This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.
Use of this website is intended for U.S. residents only.