Determining exactly how much and what type of risk a client is prepared to embrace is critical to making the right asset-allocation choices. But getting an accurate picture of a client’s investment personality is no easy task; clients themselves are often unaware of where they sit on the risk-tolerance scale.
“In order to understand your clients properly, you need to find out their dreams, their goals, their wants and their needs,” says Jim Yih, founder of Edmonton-based CORE Financial Advisors and author of Mutual Fundamentals. “You also have to figure in their past experiences and all of the other data that you would need to put together a financial plan.”
How do advisors get the information they need to assess their clients’ risk tolerance accurately? Ena Garmaise, vice president of research and development at Garmaise Investment Technologies Inc. in Toronto, says a good questionnaire is key. The best risk-profiling questionnaires encompass both the economic and psychological sides of a person’s investing behaviour.
“The reason clients can’t know their own risk profile intuitively is because it takes a lot of understanding of underlying capital markets’ movement to get an accurate picture,” says Garmaise, who develops risk-profiling surveys. Advisors need to put what a client says in the context of what he or she knows about the markets.
Advisors also need to be alert to disparities between what a client says is his or her level of comfort with certain risks and what the client really means. Sometimes, for example, clients like to think of themselves as risk-takers. Or they may want to appear that way to the advisor, believing the advisor regards high risk tolerance as a more desirable trait.
To get around that bias, Garmaise’s questionnaires avoid explicit terms such as “riskiness.” They also steer clear of language that implies risk-taking is a more positive or profitable approach to investing than risk aversion. They include questions that require choices among options with different levels of risk, but the distinction between options is not obvious.
Some of Garmaise’s questions present statements that describe varying degrees of openness to uncertainty or loss in investing. In these cases, the options are presented in varying order of risk tolerance, so it’s not obvious which answers indicate risk aversion or tolerance. “This makes it more likely that the client is actually reading the options and choosing the one that he or she prefers,” Garmaise says. “We try to convey that the questions don’t have an obvious ‘right’ answer.”
One of the 17 questions in Garmaise’s current risk-assessment questionnaire offers this statement: “I am willing to accept lower annual returns in order to minimize investment losses.” The client is asked whether this describes him or her “very well,” “somewhat” or “not at all.”
Another question asks the client to rate the statement: “I focus most on the potential for growth and less on the possibility of a negative return.”
Sometimes, advisors themselves become overly involved in shaping their clients’ thoughts, says John Kason, an investment advisor with Global Securities Corp. in Prince George, B.C. “It’s easy to project our risk tolerance as investment advisors onto our clients rather than trying to determine their risk tolerance,” he says.
Another difficulty arises when clients are asked to assess themselves, perhaps in terms of their choice of investments in the past. Often, they don’t have enough information or experience to measure the underlying risk of their investments, or to know how other asset classes in which they have not invested might better match their attitudes.
“Clients have a poor understanding of risk and the types of risk,” says Kason. “I use examples, both real and imagined. I will show them actual investments that have recently lost money and others that have made money and ask them to describe the feelings that these images create.”
Although questionnaires may generate some inconsistent responses, a good one will have each respondent leaning in one direction — toward either more risk or less risk.
One of the benefits of a good questionnaire, Garmaise says, is that it forms a record of the client’s responses. If the advisor finds that the client’s responses don’t agree with the advisor’s own understanding of the client, that’s a signal it’s time for the advisor and the client to discuss the client’s investment goals.
@page_break@Sandra Sigurdson, manager of strategic investment planning at Investors Group Inc. in Winnipeg, has developed a few techniques over the years to coax frank answers from clients. “It’s not enough just to get them to fill in the answers to a quiz,” she says. “You have to dig a little deeper to understand the ‘whys’.” It’s critical that the advisor work through the survey with the investor rather than pack him or her off with the questions to answer at home, she says.
Often, Sigurdson says, this shared exercise in temperature-taking provides an opportunity for revealing discussions. “Sometimes it will come out that the client has had an experience with something in the past that influences the way he or she invests today,” she says. “In these cases, the client’s choices are not so much about how he or she might behave in a certain situation as about how the client has behaved in the past.”
Still, advisors should take care not to assign more meaning to the results of a carefully conducted risk-assessment profile than is realistic.
“These kinds of questionnaires really relate only to investment risk-taking,” Garmaise says. “We have a certain attitude toward risk in investing that might be very different from our physical risk-taking. It’s not necessarily the case that someone who will go bungee-jumping would also take a lot of risk in his or her investing.” IE