Neal Van Zutphen turned to the power of the pyramid—his own, actually. Rich Colarossi went back to school. And Todd Terhorst and his partners redoubled their efforts at the art of client conversation. The post-2008 era in financial planning has inspired more self-reflection and practice review than any in recent memory. Client fear, reticence, and in some cases, outright rage, have reset advisory relationships for many professionals, even those who are now seeing across-the-board recovery in those same client portfolios today.
Like the advisers mentioned above, many financial planning professionals have used this three-year period of economic uncertainty to reevaluate the way they discuss, measure, and act on the risk tolerance of individual clients. In this process, many have started—again—at the beginning; that is, by reviewing all the terminology related to risk as well as the basic definition of risk tolerance. The ISO 22222 Personal Financial Planning Standard defines risk tolerance as “the extent to which a consumer is willing to risk experiencing a less favorable financial outcome in the pursuit of a more favorable financial outcome.”
Some planners have taken note of how news media and other outside stimuli might be drowning out their own customized advice, and are building an approach around that. Others have begun to reevaluate the way they’ve used diagnostic and educational materials to budge clients out of reluctance or inertia to make decisions best for their circumstances.
And some financial professionals would argue that risk tolerance isn’t the problem planners really need to attack at all. “I think we have to make a distinction between someone’s risk tolerance—their willingness to invest with the chance that their investment might go down but go up more—and risk perception, which in everyday terms is, ‘How dangerous do you think the markets are right now?’” says Michael Kitces, CFP®, CLU, ChFC, RHU, REBC, director of research for Pinnacle Financial Group and publisher of The Kitces Report, a popular blog addressing investment and practice issues for planners.
“I don’t really think planners and clients have a risk tolerance problem,” adds Kitces. “It’s a risk perception problem. Your risk tolerance means nothing if you think we’re in for another major market crash a year from now.”
There is a great amount of debate on what the lexicography of risk means for every planner and client. But there is consensus on one point: an increase in risk tolerance can’t happen without a deeper and ongoing discussion about the client’s perception of risk and how it affects his or her ability to accept an adviser’s recommendations.
“Over the years, it has become apparent that the overwhelming majority of people who seek our help have no tolerance for risk. But they actually have no clue what risk tolerance is until it whacks them in the face,” says A. Raymond Benton, CFP®, a partner in Lincoln Financial Advisors in Denver, Colorado. “It really can’t be shaped other than through repeated experience. So building a long-term relationship based on trust is the only lasting solution” toward building and increasing risk tolerance among clients.
Benton adds one more cautionary point: “Any attempt to ‘match’ risk tolerance to expected portfolio volatility is a formula for producing maximum pain and is thus a formula for failure.”
Overcoming New Client Conservatism
In January, the Investment Company Institute (ICI) reported that Americans remain committed to saving for retirement, but they “appear to have become more conservative” in terms of savings, asset allocation, and choice of retirement age.1 The survey, conducted last November and December, found that 37 percent of respondents had shifted investments toward more conservative choices, away from stocks toward bond and money market assets—even as the Dow Jones Industrial Average neared 12,000, up 70 percent from 2008’s market lows. At the same time, 17 percent reported that they had delayed retirement.
The ICI reported similar findings last September that mutual fund shareholders’ risk tolerance had not rebounded since the financial crisis in 2008.2 The organization reported that 30 percent of those surveyed were willing to take substantial or above-average risk for financial gain in May 2010, the same figure reported in May 2009—and down from 37 percent before the crisis in May 2008.
“The decline in risk tolerance between May 2008 and May 2010 was widespread across working-age mutual fund investors,” said Sarah Holden, ICI senior director of retirement and investor research, in the study. “Older investors continued to report a much lower tolerance for risk when compared with younger investors.”
Such statistics demonstrate that this more conservative mind-set, lingering a few years after the market bottom, represents an enormous challenge for advisers who worked so hard to keep clients from selling and running. Now they wonder how to get them back to a mid-point where they will consider taking on risk appropriate to their age, retirement goals, and asset levels.
Measuring and Documenting Risk Tolerance
If there is a common approach to risk tolerance, it’s that most professionals will start a client relationship with some questionnaire aimed at measuring it. Such questionnaires might come from associations, research firms, or other official sources; others might be developed by planners themselves. Beyond that, there really is no standard.
According to Sydney, Australia-based FinaMetrica, a research firm focusing on psychometrics related to financial decision making, advisers typically use a questionnaire of 5 to 20 questions for clients; however, most advisers who use them don’t know what they’re really measuring. Geoff Davey, FinaMetrica co-founder, says most of these questionnaires “deal with financial matters that have little to do with risk tolerance,” which by his definition is the amount of risk an individual prefers to take. And while age and economic conditions may affect risk tolerance on a mass level, “a lot of people think of risk tolerance as a negative, a pain threshold, but risk in and of itself is not a bad thing … nothing ventured, nothing gained,” Davey explains. “But where people strike a balance is different. Most of the time, planners are dealing with a too-much-risk scenario to achieve the goals for the client based on the client’s risk tolerance.”
Why does this happen? Davey explains that risk tolerance is a psychological trait that comes in four flavors—physical, social, ethical, and financial. Though financial risk tolerance may have absolutely no correlation with the other categories, Davey notes that some questionnaires will blend categories in hopes of uncovering some deep insight about the way clients view risk. Instead, such an approach can guide a planner’s efforts in dangerously inaccurate ways.
Davey credits Douglas Rice, D.B.A., CFP®, of Golden Gate University with some of the most reliable research on the conceptual flaws in industry-standard questionnaires. Among 131 industry-standard questionnaires tested, for those with the most conservative answers, “the percentage of assets allocated to equities ranged from 0 to 70 percent. When answered in the most aggressive way, the percentage of assets allocated to bonds, or bonds and cash, ranged from 0 to 50 percent. This is perhaps the most telling finding of the entire study.”
Most of these questionnaires don’t really measure how a client is likely to respond to a purely financial proposition. “One of my favorite sayings is that our industry is bedeviled by the superficially plausible. Some surveys date back 30 years,” Davey says, adding that American planners tend to be behind those in other countries for developing more sophisticated diagnostics not only for risk tolerance but risk capacity (how much risk clients can afford to take) and required risk (how much risk clients need to take).
Can Education Change the Risk Tolerance Conversation?
No matter how planning professionals choose to measure the initial risk tolerance of their clients, they understand that the aftermath of the 2008 crash has made it tougher to restore and increase risk tolerance for clients hesitant to take on more justifiable risk in their portfolios. More aggressive education methods might be a way to do that, but they’re not a panacea.
“Education does not increase risk tolerance, but it can help advisers guide their clients toward realistic expectations and better appreciation of the risk in markets during various cycles,” Davey says. “Risk is usually underestimated in bull markets and overestimated in bear markets.”
Planners interviewed for this article were in agreement that they are talking more to their clients and trying to respond to queries and concerns by sharing reports and research to help clients better understand the investments and strategies being recommended to them. And some are coming up with inventions of their own to get a broader picture of what clients really want out of the planning process and how far they’re willing to expand their risk tolerance.
When Neal Van Zutphen, CFP®, of Mesa, Arizona-based Delta Ventures Financial Counsel, noticed such a violent shift in client mind-set after the 2008 crash, he decided to take time out to do some research on risk tolerance with a humanistic touch. The result was a three-dimensional visual aid called the Happiness Risk/Reward Pyramid that planners can use with their clients to address unmet personal and financial needs, life goals, and potential obstacles toward meeting these goals. Van Zutphen detailed in a contribution for the Journal3 how he drew on Elisabeth Kubler-Ross’s five stages of grief and Abraham Maslow’s hierarchy of needs theory to address how clients handled loss on an intimate basis while giving them a chance to examine what they really wanted out of life.
“Several years ago, I began a research project on the psychology of money. In the past, when we had conversations on risk tolerance and how we should manage their portfolios—risk management—the clients would get a glazed look on their face. Everyone knows about the eggs-in-one-basket sort of thing, and frankly, it was more sales-y than educational,” says Van Zutphen. But, particularly after 2008, Van Zutphen and his colleagues were facing the added pressure of communicating with clients who were hearing negativity from all corners. “You’d hear them talking about [CNBC commentator Jim] Cramer saying the world is going to hell in a handbasket, and our clients were getting so wrapped up because bad news sells really well,” he explains.
So Van Zutphen decided to create his pyramid and hit the real enemy head-on—fear. Discussion of bad events, both financially and personally, became the subject of extensive conversations. “When bad things happen, people go through stages of grief,” he explains, and going through those feelings helps diffuse the guilt and anger associated with them so clients can accept the event and start making adjustments to catch up.
“Risk tolerance is contextual,” Van Zutphen explains. “For clients, it’s all predicated on their current situation and how they view the future. If someone gets a new job with a $50,000 raise, you bet their risk tolerance goes up, even if they are in fact a moderate risk taker. If there’s bad news they feel involves them, it’s the same effect.”
Back to School
Rich Colarossi, CFP®, of Colarossi & Williams in Islandia, New York, has “never believed in risk tolerance questionnaires. They’re silly. It’s a snapshot of a client’s risk tolerance, and not a particularly good one.”
Yet the post-2008 environment called for a different sort of action. “We had people who got through 9/11 and were able to handle volatility. But once 2008 hit, they couldn’t. Something major had changed,” says Colarossi. There was a loss of perspective that seemed worthy of additional focus. So in the months following the crash, Colarossi enrolled in the New York University School for Continuing and Professional Studies to study behavioral finance and economics.
“I felt I needed a better way to understand what the client really is thinking. In all my years of practice, I always had one or two clients who were hard to move and convince,” Colarossi says. “But you saw more of that after 2008. It would go something like this. Say the client invested $100,000, their portfolio hit $150,000 at the top, and then after the downturn went to $130,000 … and then they couldn’t move. Overall, they still had a gain, but I had to learn how to effectively get people out of a loss mentality when they were invested long term.”
Colarossi believes planners need to have deeper conversations now on the difference between risk and uncertainty. “We need to get people better aligned with their goals and time horizons. That’s a healthier way to handle clients.”
“Three years ago, I would have been more reliant on quantitative analysis,” he continues. “Now I don’t even bother. I take a closer look at how they’ve reacted to loss in the past … [and] focus on what loss really means to them.”
As to the current mind-set of clients, “Even though it’s calming down now, there is a greater fear of loss. There’s no question about it. The pain of loss is a killer,” says Colarossi. To an extent, Colarossi also blames the media for ramping up the negativity. So he spends more time talking to clients. “It’s an investment of time, but isn’t that what the client wants? Isn’t that what they’re paying me for?”
Joseph Matthews, CFA, CFP®, resident director of wealth management for Merrill Lynch in Westport, Connecticut, helped develop the course Colarossi took as an adjunct professor for NYU in 2008, and teaches it today. The topics featured in the class include heuristics (the theory that people often make decisions based on generally accepted rules rather than rational analyses), framing (the different ways an individual reacts depending on how ideas are first presented), and anomalies (how efficient market theory’s unexpected and unlikely events continue to occur—and why they do). He focuses heavily on the work of two economists and collaborators in the field of behavioral economics: Nobel laureate Daniel Kahneman of Princeton and Richard H. Thaler of the University of Chicago’s Booth School of Business.
According to Matthews, 2008 was the year “that modern portfolio theory went out the window. Fear became the overriding factor that took precedence in many [planner-client relationships] and a lot of people were looking for answers.” In the past three years, his students have included planners, but he’s also taught portfolio and hedge-fund managers, equity traders, fixed-income analysts, brokers, and wealth management advisers.
“I would say that individuals come into the program with a notion of believing that behavior has in some way, shape, or form an impact on capital markets,” says Matthews. “They come out believing that behavior can often be the most important factor affecting markets.”
Matthews notes that his students and fellow professionals have really gone back to school on the subject of risk and explaining it to clients. The most effective tools, he believes, still rest on empirical data, such as the simple presentation of an investment class’s history during turbulent times. And the historical performance data from 2008–2009 will undoubtedly add significant weight to that approach.
“To be able to say to a client, ‘Your $2 million portfolio could be worth X if this set of factors happens again,’ is at the very least a way for clients to see the possibilities and judge if that’s where they really want to be. It’s right in front of them,” says Matthews. “Exposing clients to historical down cycles for various asset classes can only help. Then they’re not dealing with the conceptual. They’re dealing with history.”
Putting Risk in Client Terms
Todd Terhorst, CFP®, CLU, ChFC, AAMS, CRPC, president and managing partner of Diversified Wealth Management in the Twin Cities, Minnesota, says the process of measuring risk tolerance at his firm hasn’t changed dramatically, “but enough where we had to rethink how we talked to clients about risk and how we describe risk.” Part of the process his firm has changed is taking the time to ask clients how they describe risk in their own words, says Terhorst, “because clients don’t always describe and think of investment risk in the way we do.”
The conversation starts with a risk tolerance questionnaire, but risk is now an extensive part of client discussion, which rarely happened at any length pre-2008, Terhorst says. Regular attention to the subject of risk has its benefits: “When I meet a new client and ask them how risky their current portfolio is, I’ll get 10 different answers in one conversation. But after two to three years with us, I find we sound more alike because there’s more information being exchanged and more understanding. That’s what’s supposed to happen.”
Not that risk tolerance doesn’t vary over the life of the relationship, says Terhorst, but both client and planner need to see whether a client’s actual risk tolerance reflects the investments they’re in, and if not, whether the client’s risk tolerance needs to be tweaked in some way so realistic goals can be reached. To get there, the opening question can be very basic: “On a scale of 1–10, with 1 being your money being buried in the back yard and 10 being 100 percent exposed to equities, where does your comfort with risk stand?” Terhorst explains. “I wouldn’t have used that simplistic a starting point in years past, but today, even if it seems a little silly, whatever you can do to make sure you’re on the same page with a client is worthwhile.”
Terhorst also asks new clients a question about their behavior at the end not only of 2008 but of 2001 as well. “If a client tells me they lost 10 percent and went to cash by the end of those years, that’s telling me a lot. That’s an actual point of pain; that’s behavior. And planners need to hear that so they have something to work from in making future recommendations.”
The actual charts-and-graphs side of the discussion has changed too. “I used to talk in terms of returns, which we still do, expectation of returns. But one of the things that we used to gloss over because we felt the client would start to nap was measuring beta,” says Terhorst. “For instance, comparing their stock portfolio to the performance of the S&P 500. A beta of 1.0 would mean both investments had the same amount of volatility. So, in 2008, if your portfolio went down 20 percent, you lost as much as the S&P, which makes people a little more comfortable in the risk discussion. They could see the bigger picture.” Beta, says Terhorst, can be used not only as a way to gauge overall risk and performance but as a thermostat to adjust risk levels in portfolios over time.
How often should risk be discussed? “As often as you discuss the portfolio,” says Terhorst.
Where Compliance Comes In
The financial professionals interviewed for this article agree that the biggest impact heightened compliance rules around risk have had involves how advisers document and handle transactions and recommendations they make in response to client risk assessment. Compliance issues don’t actually govern the length, detail, or emotional punch going into the new risk conversation.
“Certainly, some firms are asking for more detailed records and documentation that might change the process an adviser takes with the client,” Terhorst says. “Being that I am an OSJ and Series 24 licensed principal for my firm, I see firsthand how the compliance issue is handled from both sides. If the rep is changing the way they discuss risk with their clients only because of compliance, it is likely they weren’t doing their job properly prior to any heightened requirements being put in place.”
Lisa Holton heads The Lisa Company, an Evanston, Illinois-based writing, editing, and research consulting firm founded in 1998.
ICI Study. 2011. “Some U.S. Households Making More Conservative Financial Decisions Since 2008 Economic Downturn.” www.ici.org/pressroom/news/11_news_com_ret.
ICI Study. 2010. “Mutual Fund Shareholders’ Risk Tolerance Has Not Rebounded Since the Financial Crisis.” www.ici.org/pressroom/news/10_news_ownership.
Van Zutphen, Neal. 2010. “A Visual Aid for Successful Financial Planning: The Happiness Risk/Reward Pyramid.” Journal of Financial Planning 23, 1.