What can advisors do to help investors break a cycle of buying high and selling low? Gauging a client's risk tolerance can be challenging. From 1997 to 1999, many formerly conservative clients were demanding that advisors allocate up to 100% of their portfolios to large-cap growth stocks. (Smart advisors pushed back and saved their clients some pain soon in the bust that followed.)
A decade later, clients were demanding that advisors scale back - or eliminate - U.S. equity holdings just as the market was about to hit bottom and rally. Now, investors are pouring money into equities they shunned four years ago.
The best answer, of course, is to make sure that clients' portfolios are aligned with their long-term goals. The primary tool for this type of analysis is financial planning software.
Another important tool is high-quality risk-assessment software. If you build a portfolio that has a high probability of declining 20% in a bear market, but your client can tolerate only a 10% drop before panic sets in, the odds increase that the client will bail out near the bottom. Unfortunately, until you've been through a bear market with particular clients, it is difficult to know just how risk tolerant they are likely to be.
A third necessity for keeping clients on course is a portfolio-construction tool. Assuming you can get a fairly reliable reading of a client's risk tolerance, you need to be able to create portfolios that align with this level - so that when the next bear market arrives, clients will withstand it because their losses do not exceed what they can comfortably bear.
I recently tried a new cloud-based product called Riskalyze Pro that provides advisors with both risk-assessment and portfolio-construction tools. The tool was developed by Riskalyze Advisors, a new company whose proprietary platform provides risk assessment, portfolio construction, analytics and investment discovery. The three principals all have technology backgrounds, but the CEO, Aaron Klein, appears to have a good understanding of the lapses in judgment that many individual investors fall prey to - and he believes he has built a superior solution to address their needs.
The firm started off last year by offering a free and simplified consumer version of its software, which helped validate it before it was offered to advisors. While the testing time was short, the results have been promising. Last year, customers built portfolios exceeding $2 billion on Risk- alyze - and of these portfolios, only 1.6% fell outside the users' projected risk parameters. Clearly, last year was not the ideal test case for Riskalyze - it would have been interesting to see how it performed in more volatile markets five years ago - but the track record to date is solid.
The Riskalyze process starts with a well-designed questionnaire, which Klein suggests advisors email to prospects before an initial meeting. It asks first for any recent changes in a client's financial status (employment, inheritance, etc.), then questions the user about financial goals (retirement, paying down debt, etc.).
Then it starts the risk assessment by asking for two numbers: an investment amount and a devastation amount. The devastation amount is supposed to be the prospect's assessment of the dollar level that his or her finances might never recover from. For example, if the investment amount was $500,000, a retiree might feel that a $100,000 drop (to $400,000) would have a material negative impact.
The application offers other questions to further assess risk tolerance. It asks users to choose between a guaranteed outcome and some sort of 50/50 outcome. The user would be asked to choose between a 100% certainty of a 10% gain and a 50/50 chance of either a 20% loss or a 50% gain. If the user is willing to risk a 20% loss, the application notes that the devastation amount may not be low enough. If the user chooses the certainty of a 10% gain, the program asks about the certainty of a 5% gain versus the same 50/50 choice, and continues asking questions until it can offer a risk tolerance projection. This is called the risk fingerprint, and it is a proprietary score on a scale from 1 to 100.
Our hypothetical prospect scored a 70 - indicating a willingness to risk a 15% loss for the opportunity to make 23%. (The model uses historical market returns, but only uses data since 2008 for correlations and volatility. It assumes returns will be distributed normally. The range of returns presented indicates a probability of about 95% that returns will fall within the specified range.)
The prospect is then asked if those numbers feel about right. If the answer is "yes," the results are sent back to the advisor. If "no," the risk assessment continues.
Once the risk assessment is completed, an alert is sent to the advisor's dashboard within the application. After the advisor has reviewed the answers, the next step would be to collect data on the client's current holdings and enter them into the system. When this has been completed, the application displays a risk fingerprint for the portfolio, an asset allocation pie chart and other metrics.
Armed with this information, the advisor can see immediately whether client portfolios are in alignment with their risk fingerprints. Riskalyze also includes a built-in optimizer: Even if a client's portfolio is aligned with the risk fingerprint, the tool would highlight opportunities to increase expected returns for the current level of risk or to lower risk for the same expected returns.
The application comes with five simple packaged portfolios, with risk fingerprints ranging from a low of 22 to a high of 74. Advisors can also modify one of the packaged portfolios by adding or subtracting assets, or they can create custom portfolios, allocating assets for a fixed level of risk. As they add assets, they can see the impact each has on the overall portfolio's characteristics.
Overall, there's a lot to like. The product is quick and easy for the client. The results displayed - the single risk fingerprint number along with the range of returns it represents - seem easy for a client to understand.
The free, basic Riskalyze Pro version gives advisors all of the features except the ability to create models with individual holdings (you are limited to asset-class models). The paid version, which cost $99 per month per user, also offers an additional feature: the ability to label the software with your logo. If you plan on incorporating Riskalyze into your prospecting or investment process, the paid version may be well worth the price.
The graphics are also very client friendly. You can print out analyses of clients' current portfolios to show the spread between their risk fingerprint and their holdings. You can also change the screen to show additional information: a risk/reward heat map, to identify the holdings that are adding the most portfolio risk; a dividend yield map, to show which assets are generating current income; and an expense ratio map, to display which mutual funds, ETFs and other assets are most and least costly.
Riskalyze is compatible with mobile devices. It worked fine in tests with different browsers.
The risk assessment methodology is also praiseworthy. It is based upon sound economic principles and the assessment takes only minutes. It is a great marketing tool because it offers prospects a free risk assessment and helps them understand whether their current investments are out of alignment with their risk fingerprints. You can then offer to help them fix the problem(s).
Riskalyze is also useful with compliance by documenting a client's risk level. If a question ever arises as to the appropriateness of a portfolio, you have all of the client's responses at your fingertips.
One missing element of Riskalyze is integration. It's a significant omission: If you sign up for Riskalyze, you should be able to email risk questionnaires to all of your existing clients from within your CRM software, without re-keying the data manually. But you can't.
Klein says that users will soon be able to import a CSV file with the data, but that's so 1995. A modern app like this should do better. Better integration would also let users receive alerts about returned questionnaires directly into their CRM - the app that many advisors use to manage their businesses.
Integration with portfolio management software and custodial platforms would allow advisors to upload portfolios from those apps, instead of having to enter them manually. And even if data does have to be entered manually, it would be nice to have the option of entering dollar amounts and have the program calculate the percentages.
Some planners will no doubt take issue with the way Riskalyze analyzes risk and optimizes portfolios. Since it uses a normal distribution to calculate risk, some could reasonably argue that the model will tend to underestimate the likelihood of a black swan event.
I also have some reservations about the devastation amount. Although the number gives a good sense of a client's risk appetite, it might not accurately reflect the amount he or she can afford to lose without seriously impacting financial security.
Finally, Riskalyze needs to improve its update process. I logged on one day at 2 p.m. and my portfolios had disappeared. When I called Riskalyze, I was told the firm was in the middle of a system update - not an ideal time for an upgrade!
Riskalyze is hardly the only risk-assessment tool out there.
MoneyGuidePro offers a very nice tool as well, but it is available only to MoneyGuidePro subscribers.
FinaMetrica is another popular risk-assessment tool. At $990 per year per advisor (as low as $840 on a three-year contract), it is less expensive than Riskalyze, but the assessments take longer for prospects to complete, and there is no portfolio-construction component. Fina- Metrica does, however, offer integration with a number of financial planning and CRM applications, as well as custodial back offices.
Riskalyze is a welcome addition to the risk assessment tools advisors have at their disposal. It can serve as an effective marketing tool - a risk assessment tool that is both easy to use and easy for clients to understand - and a portfolio-construction and -optimization tool. It has only a very short history, and the risk model may require some tweaking over time, but so far it is performing well.
Yet integration with leading CRM applications seems essential for Risk-alyze to flourish in the independent RIA space, and integration with portfolio management software and custodial platforms is also highly desirable. I suspect those integrations will come soon to the paid version if Riskalyze Pro succeeds in attracting clients. The company may also need to lower the price a bit to build a client base rapidly.
Joel Bruckenstein, a Financial Planningcolumnist, is co-creator of the Technology Tools for Today newsletter, conference series and technology guides for advisors, including the new Technology Tools for Today's High-Margin Practice. For more information, visit JoelBruckenstein.com.