Assessing Clients’ Risk Appetite and Sophistication

Journal of Financial Planning: September 2021

 

Daniel Yerger, CFP®, ChFC, AIF, CDFA, is the founder and president of MY Wealth Planners in Longmont, Colorado. Yerger, an Army veteran, serves on the editorial advisory board for FPA’s Next Generation Planner.

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This month, we’re taking a look at two pieces of recent research on risk tolerance and risk capability. Suitability and the assessment of risk when investing are important functions of a financial planner’s planning and investment management process. Without an accurate assessment of a client’s risk tolerance, a planner might be surprised when a client is underwhelmed by their portfolio’s performance or when the client is upset at short-term investment losses. As clients age and cognitive capacity potentially wanes, it becomes even more important that financial planners understand their clients’ ability to understand the risk in their portfolios, and sometimes the role of the planner shifts from the growing of assets to the preservation of a client’s finances.

 

A Deeper Dive: A Mixed Methods Approach to Risk Tolerance

By Meghaan Lurtz, Ph.D.; Kristy Archuleta, Ph.D., LMFT; Michael Kothakota, Ph.D., CFP®; and Timi Joy Jorgensen, Ph.D.

Risk tolerance is a hot topic, not only for financial planners but also for fintech and regulators. While many firms have emerged over the past several years touting claims of having invented a “better risk tolerance measure,” research on risk tolerance has historically raised questions about the efficacy of surveys and questionnaires to properly assess risk. Alternatively, while some view risk tolerance measures as a waste of time, preferring to let their financial planning process tell them the appropriate risk level for a client, regulators often take a cold eye to firms that run astray from assessing suitability and the appropriate level of assets for clients.

Regardless of the motivation, accurately assessing risk tolerance is more difficult than many would like to admit. Most assessments of risk tolerance rely upon a single mode of assessment, either a stated preference (e.g., “On a scale of one to 10, how risk-tolerant are you?”) or a revealed preference (e.g., software that presents clients with various market scenarios and questions how they’d respond). Ultimately, both come with significant limitations. Many assessments attempt to quantify something that may not be fully measured in a numeric form.

Recognizing these limitations, the researchers in this study attempted a multi-modal approach to assessing risk tolerance by examining stated and revealed preferences, measuring risk literacy, and evaluating external factors such as income and feelings about the market’s future. Upon completing their study, the researchers recommended a multi-step approach planners could use to understand a client’s risk tolerance more holistically. An example given was to ask a client to describe their tolerance on a scale of one to 10, followed by questions about why they gave that answer, rather than the adjacent figures and asking them to describe what informed their decision to score themselves as they did. They also suggested that planners may want to test or otherwise interview a client to better understand their risk literacy, as clients often interchanged terms such as “luck” or “gambling” with their definition of risk. Finally, the researchers highlighted the tendency that clients ultimately do not want to assume undue risk to accomplish their goals and only want to accept as much risk as is required to accomplish their goals. This should inform planners that recommending overly aggressive allocations may not be appropriate when a lower risk level is likely to accomplish a client’s goals, even if a client verbally states a high risk tolerance or has a longer time horizon that otherwise suggests an increased risk tolerance.

 

The Unsophisticated “Sophisticated”: Old Age and the Accredited Investors Definition

By Michael Finke, Ph.D.; Tao Guo, Ph.D., CFP®, CFA; and Sandra Huston, Ph.D.

As fiduciaries, financial planners have a special responsibility for their clients to make recommendations in their best interest and act with a duty of loyalty and a duty of care. Both ethically and by law, part of those duties is to protect seniors from financial exploitation and undue risks. Even the low bar of suitability indicates that there are inappropriate investments for seniors. However, concerningly, the current hurdle to some of the riskiest and most speculative investments available is the “accredited investor” definition, which uses income or net worth as a proxy for sophistication. This study examined seniors’ exposure to the risk of financial loss through the examination of qualification for accredited investor status while simultaneously having less financial sophistication or cognitive capacity. The study indicates that 3.7 percent of the U.S. population is over the age of 65 and meets the accredited investor definition while holding 30 percent of household wealth in the country. Yet financial sophistication scoring for seniors, particularly those over 80, is lower than the group of non-accredited investors in their 60s and 70s. It would then seem appropriate to observe that the financial measures proxy for sophistication does not serve its purpose in protecting investors from “risks they can handle,” particularly as age becomes a more relevant factor. The underlying assumption that income or assets equate to sophistication fails to consider the cognitive capabilities of investors at older ages, particularly as old age is significantly correlated with meeting the accredited investor requirements. Despite the fact that accredited investors in general score higher in cognitive tests, there is a rapid decline in cognitive capability scores past the age of 80. It is therefore likely that financial planners must remain vigilant for the possibility that their senior clients may be interested in investments they do not understand but also more vulnerable to solicitation of high-risk and speculative investments that they may no longer have the financial capacity to recognize as risky for their personal financial needs. Ultimately, it may be on financial planners to be the voice of reason when the suitability or desire for speculative investments arises

 

References

Finke, Michael, Tao Guo, and Sandra Huston. 2021. “The Unsophisticated ‘Sophisticated’: Old Age and the Accredited Investors Definition.” Financial Planning Review 4 (2): e1114.

Lurtz, Meghaan, Kristy Archuleta, Michael Kothakota, and Timi Jorgensen. 2021. “A Deeper Dive: A Mixed Methods Approach to Risk Tolerance.” Financial Planning Review 4 (2): e1112. https://doi.org/10.1002/cfp2.1112.

Topic
Investment Planning
Research