There is a serious problem with the way many advisors approach clients’ risk tolerance.The traditional practice — which has been enshrined in the standard regulatory process for determining the suitability of a recommendation — looks at two key factors regarding risk: a client’s attitudes about taking risk and financial ability to do so (for example, available assets and time horizon). The advisor then combines the two into a composite score that can be assigned to a portfolio.

Positive attitudes toward risk, plus the financial ability to take it, get a high score and, in turn, an aggressive portfolio. A poor attitude toward risk, coupled with significant portfolio needs, yields a conservative portfolio — and a mixture of the two factors usually leads to a moderate-growth portfolio.

Yet there’s a fundamental problem with this approach: It confuses someone’s capacity to take risk with their actual need or desire to do so. As a result, wealthy clients who don’t want or need risk are still given (unnecessarily risky) moderate growth portfolios, young clients who have a long time horizon but no desire for risk end up with equity-centric portfolios that may scar them for life, and clients with unrealistic spending goals receive impossibly conservative portfolios that will doom them to failure.

The solution to this challenge is a fundamental change in how we view risk tolerance and financial risk capacity in the first place. The optimal portfolio solution is not reflected in a combined score of risk tolerance and risk capacity. It’s crucial to separate out our evaluation of whether someone needs risk, whether they can afford risk and whether they want to take risk, so the ultimate portfolio recommendation can properly align all three.

RISK CAPACITY

In the standard process of evaluating risk tolerance, the advisor usually asks a wide range of questions regarding the client’s financial and mental ability to withstand risky events. The financial questions — which might be related to the client’s need to tap assets for income/withdrawals, the time horizon of the goal and the availability of other assets — actually speak to the person’s risk capacity. In other words: To what extent could a risky event, like a market crash, occur without damaging the underlying financial goals?

If clients don’t need money for decades, a near-term disaster won’t affect their goals. If they aren’t withdrawing anything from their portfolios and it’s just a small slice of overall net worth, then again, a near-term disaster won’t impact the goals. These would be clients who have a high capacity for risk.

By contrast, if the goal is to take significant ongoing withdrawals, starting immediately, there is a far lower capacity for risk. If something bad happened, the goals would be in serious danger.

Once you separate out the purely financial matters, true risk tolerance becomes strictly focused on a client’s attitudes about risk. Does the client have the mental inclination and desire to pursue a more favorable outcome at the risk of getting a less favorable result?

These attitudes about and tolerance for risk have nothing to do with the ability to afford risk — they are simply about the desire to pursue actions or goals that entail risky trade-offs (or not).

From this perspective, risk capacity becomes a measure of how risky the client’s goals really are: Do the goals require a high rate of return just to have a chance of success, or is the goal so low risk that even a bad market outcome can’t derail it?

Risk tolerance, meanwhile, measures how much of a risky trade-off the client is willing to pursue. The key: It’s crucial to be certain that neither the portfolio nor the goal is riskier than what the client can actually tolerate.

In the illustration below, the client has a relatively conservative goal on the spectrum and a portfolio that should be able to attain a return slightly in excess of that necessary to achieve the goal. Most important: Both the portfolio and the goal are more conservative than the client’s maximum level of risk, as indicated by their tolerance.

2 SAMPLE CLIENTS

To understand why this distinction between risk tolerance and risk capacity is so important, imagine two hypothetical clients: Joe and Betty.

Both are highly averse to risk; if you gave them a questionnaire asking about their attitudes toward and willingness to take risk, both would earn the lowest possible scores. If you asked them, “In a bear market, would you: A) Buy more; B) Just hold tight and stay invested; or C) Sell some of your portfolio,” they’d answer, “D) SELL EVERYTHING IMMEDIATELY!”

But they have different goals.

Joe plans to retire in about 15 years. His income goal is about $15,000 a year, from a portfolio projected to be at $1.5 million by then. So Joe has what we’d call a high capacity for risk; if something horrible happens in the market, his future withdrawal rate would go from 1% to 2% — still extremely conservative. Even if something bad happens to Joe’s portfolio, his goals will be fine.

Betty’s plan, on the other hand, is to start tapping her portfolio immediately, and she needs about $65,000/year (inflation-adjusted) from her $1?million portfolio to achieve her goals. As a result, Betty actually has a low capacity for risk; if something bad happens to her portfolio, her goals are in serious jeopardy, as a 6.5% withdrawal rate is a dangerous proposition. Viewed another way, Betty’s goals themselves are very risky.

Using a traditional risk tolerance approach, Joe would answer a long series of questions about both his financial capacity for and views on risk. His long time horizon and low need for income would give “high” scores, while his poor attitude about portfolio risk would get a low score. The likely end result: Joe would receive a score around the middle on the questionnaire, and he would end up with a moderate-growth portfolio.

Using a similar traditional risk tolerance questionnaire approach with Betty, the responses regarding financial capacity would indicate a limited time horizon and a high need for income, while she too would show a low tolerance for actual portfolio risk. Betty would likely get one of the lowest scores possible on the risk tolerance questionnaire, and accordingly would receive an ultraconservative bond portfolio.

Note the outcomes achieved with the traditional approach. Joe has received a portfolio that virtually ensures that he will someday have a personal financial crisis, because we’ve given a client with no actual tolerance for market declines a moderate-growth portfolio. We’ve also given Betty a portfolio that virtually ensures that she’ll someday have a personal financial crisis — because we’ve assigned an unsustainable bonds-and-cash mix to a client who’s targeting a 6.5% withdrawal rate.

POTENTIAL DISASTER

The end result of the traditional approach: You have two clients on the road to personal crisis and potential disaster.

Joe received a portfolio that will give him far more risk than he can tolerate. Just because he can afford to take the risk doesn’t mean he should, because he doesn’t need that risk in the first place. (Remember, he just wants to spend 1% a year starting in 15 years.)

With Betty, the problem is that she has goals that are inconsistent with her risk tolerance, for which there is no portfolio solution. The real conversation with Betty should not be about whether to have an aggressive or conservative portfolio to achieve her goals, but about the fact that she needs to adopt more realistic goals that better align with her risk tolerance.

BAD COMBINATION

The sad reality is that the combination of risk tolerance and risk capacity into a single measure has been so enshrined in today’s regulatory environment that the aforementioned disasters for Joe and Betty would probably be entirely defensible to most regulators.

Still, in executing financial planning in the best interest of the client, it’s time to separate risk tolerance from risk capacity. Just because clients can afford to lose money doesn’t mean they should be invested to do so, whether it’s a retiree with conservative spending goals or a 25-year-old investor with a multi-decade time horizon.

This has ramifications for both the advice traditionally given to young people — “You should have a mostly stock portfolio, because you have a long time horizon and can afford to take the volatility” — and the process used with retirees (measure risk tolerance on a standalone basis, and only then compare it to their needs, goals and time horizon).

If advisors “over-risk” young clients and give them an early bad market experience, they could become so fearful that they walk away from the equity markets for good. With wealthier clients, we may unwittingly be risking capital they never wanted, needed nor intended to risk in the first place.

Of course, advisors shouldn’t neglect the other key aspect of managing risk for clients: providing the ongoing education and expectations management necessary to keep their perceptions of risk in line with what’s actually happening in their portfolios.

And it’s important to recognize there are still better and worse ways to measure risk tolerance in the first place. While many prefer a conversational approach, advisors may unwittingly bias client responses through the manner in which they ask the questions. Research has shown that even the gender of the person asking questions can influence client response.

Consequently, best practices should probably include some form of psychometrically designed risk tolerance questionnaire that just measures risk tolerance; advisors can then explore and validate the results through a follow-up conversation.

The point is not that all risk tolerance questionnaires are “broken” or unusable, but that our industry standard of mixing together risk tolerance and risk capacity questions doesn’t work.

As long as we continue to mix questions about whether someone can afford risk with whether they wish to take the risk, we’ll end up putting clients into portfolios that give them risk they cannot tolerate simply because they can afford it, and will fail to identify situations where no portfolio can achieve the desired goals.

Once pure risk tolerance is viewed as what it should be — a constraint on portfolio (and goal) risk, regardless of time horizon and financial capacity — it becomes far easier to align tolerance, portfolios and goals.

Michael Kitces, CFP, is a Financial Planning contributing writer and a partner and director of research at Pinnacle Advisory Group in Columbia, Md. He’s also publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.

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