With the majority of client complaints alleging unsuitable investments and/or strategy — and even great scholars having difficulty defining the essential elements of risk tolerance — what are advisors to do?
Here are some guidelines to consider to help limit the risk you face as an advisor from such potential allegations:
1. Don't underestimate the value of dialogue. When engaging in exploratory discussions with clients, avoid closed-ended questions, interrupting clients and answering for clients who don't answer immediately. Thoughtful answers can require giving the client time to think, which will produce answers that are more aligned to how the client thinks about risk.
2. Helpful questionnaires do not replace dialogue. Use client questionnaires as a guide rather than a bible, so that you promote discussion between you and the client instead of producing one-word answers or a tick in the most relevant box.
3. Review the factors that impact risk tolerance. There are various factors that can impact a client's risk tolerance, such as his or her actual assets, liabilities and ongoing financial obligations (cash flow). This is not simply information that you get from clients to complete a form; these factors can have a major impact on the types of investments that are, or are not, suitable for them. These issues can impact a client's actual ability to tolerate a loss financially.
4. The client's emotional ability to withstand the stress of losses. Consider making a list of questions or identifying these on a questionnaire that assist with the exploration of both the actual and emotional ability of a client to withstand losses in his or her portfolio. Then, prepare a list of the issues that fall into each of these two categories — I like to use a chart — that helps you and the client identify the issues that impact his or her risk tolerance.
For example, a client may be in a great financial position with great cash flow, but you may identify that the client grew up in a family that had a terrible time making ends meet, which caused the client a lot of stress. You may identify that this client's emotional reaction to losing any capital may not be something he or she can tolerate emotionally and this needs to be both explored and identified. You don't want to learn this about a client during a market downturn, after money is lost, as it may be too late at such a point to avoid a complaint to the regulator or being sued.
5. Don't underestimate the need for a paper trail. Ensure that you have notes of what the client told you during meetings, as this is crucial to being able to prove the client's risk tolerance. You may be familiar with my 4 Cs of documentation — correct, complete, consistent and contemporaneous — that I presented in my book, Advisor at Risk.
In general, advisors complain that it's difficult to take notes when they are speaking. Although that's true, you can create an agenda and jot down just a word or two under each heading to reflect what you said. Even more important is writing down what the client tells you. It's far easier to take notes while a client is speaking so write it all down. If you use a laptop, then type it all in. Put in quotes any good questions the client asks that reflects his or her understanding of the risk and the investments.
It's difficult to pin down exactly how to define risk tolerance exactly, but this list of five considerations can help you navigate this very complex issue while protecting yourself in the process in case the client later complains that the investments or strategy you recommended were unsuitable.