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Clients Lie … to Their Advisor and to Themselves

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Clients Lie

Much of an adviser’s time is spent trying to understand and quantify their clients’ true comfort with risk.

In most cases, it starts with a conversation about the client’s current position and future needs, then the advisor and client develop a financial plan, and, finally, the client completes a tolerance questionnaire to aid in formulating a specific investment strategy. 

The financial planning industry has dedicated considerable effort to developing approaches to help advisers determine a client’s risk tolerance relative to investment positioning. Companies such as Riskalyze, FinaMetrica, Tolerisk, and Finmason have all spent time, brainpower and funds to work on this problem. We have even seen large broker-dealers, such as Cetera, employ technology that reads facial cues in an attempt to refine their understanding of the client’s risk tolerance. 

What is lost in this exercise of analyzing a client’s responses and body language is that the client lies.  They lie to their adviser and to themselves. They lie today about how they might feel tomorrow.  They lie about how they felt in the past when periods of market disruption occurred. They just… lie.

Lie might be a harsh word—you can call it misremember or misjudge, if you prefer— but it is no less true. The client’s attitude toward risk-taking depends on how they woke up that morning, how the market has acted recently, how their accounts are doing, etc. The one thing we know about humans is that their perspectives change, and their behaviors adjust based on their outlook on life. If a person is months away from retirement and the market falls materially over a short time, with headlines expressing the worst, they will adjust their outlook and likely their portfolios, as well—and at the worst time.

The industry has attempted to factor this into its analytical tools by providing scenarios of anticipated losses in a market correction, but action is still based on the person’s view at that one point in time when they were asked the question about tolerance. Ask the very same question to the same person when markets adjust down 10% over the course of a week, and the response will likely change. 

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Understanding this helps explain research by Morningstar and Dalbar, where each have estimated that clients’ behavior has reduced their returns, relative to the benchmark, by 2% to 5% per year. The reason is clear, clients adjust their risk tolerance in response to market moves.  Although a better means of assessing a client’s risk tolerance could conceivably lower that drag, it will always suffer from the volatility of human emotion.

The industry must accept that clients change their perception of risk based on the gyrations of their portfolios and should plan accordingly.  It can start with a change in the conversation to revolve around “the plan” and how the volatility in markets was factored in.  But aside from behavioral coaching, the investment selection will play a critical role.  Selecting investment strategies that can adjust to the changing fear and greed demonstrated by markets can soften the hit to a portfolio, easing the conversation and making for a better overall client outcome.

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