There’s a really good article today on the website OnWallStreet.com. Author Brad Klontz, a certified financial planner and financial psychologist, cogently explains the flaw in the traditional way brokers, investment advisors, and financial planners assess a new client’s risk tolerance. According to Klontz, the usual practice of using questionnaires or checklists to have the client self-report his or ability to tolerate risk is mainly designed to protect the financial professional rather than the client. Klontz states:
We use that risk tolerance score, along with a consideration of the client’s assets, desired rate of return, income needs and age to place the client into an investment objective category, such as aggressive growth, growth and income, balanced, income or some other iteration.
For most advisors, this is where the risk tolerance assessment process ends. The reality is that the traditional risk tolerance assessment is mostly a “CYA” [i.e., cover your ass] procedure. Unfortunately, the psychology of risk tolerance is more complicated than what today’s questionnaires measure. Risk tolerance is a multidimensional, fluid construct affected by many factors.
After discussing those factors and providing an example of a “best practices” discussion between advisor and client regarding risk, Klontz concludes:
In the end, risk tolerance is not stable. Rather, advisors should monitor a client’s perception of their willingness to accept risk tolerance (which they will tell you) and their actual risk composure (which they will show you in the next market downturn) throughout the relationship. As advisors, we do our clients a disservice if we naively mistake their self-reported risk tolerance for their actual behavioral tolerance to accept portfolio losses.
The entire article is well worth a read, and you can find it here.
Hugh Berkson is a Securities Attorney with McCarthy, Lebit, Crystal & Liffman, Co. LPA. Hugh is rated AV® Preeminent™ by Martindale-Hubbell®.
He obtained a business degree in Finance from the University of Texas at Austin in 1989, and is a 1994 graduate of Case Western Reserve University School of Law, where he was a member of the Order of the Barristers and received both the American Jurisprudence Award, (National Mock Trial) in 1993 and the Jonathan M. Ault Mock Trial Prize for 1993-1994.
