In the investment industry, we think risk equals standard deviation. Therefore, risk can be measured, and the amount of risk we take can be controlled. It's a nice, clean way to fit risk into our models. If clients can handle more risk based on their answer to our "risk tolerance" questionnaire, we just turn the dial, and increase their allocation to equities.
The problem is that when real people, in the real world, think about risk, I am almost positive they don't ever use the term standard deviation. Can you imagine a client losing sleep because they are thinking about the high level of standard deviation in their portfolio?
Real people lose sleep because they are worried about not having the money to fund their most important goals. They lose sleep thinking about not having the money to send kids to collage or retire. To real people, risk equals not meeting their financial goals.
We are measuring their tolerance for fluctuation, while they are worried about running out of money.
Now, maybe you can make the claim that standard deviation (using Monte Carlo analysis) is one way of quantifying the possibility clients have of not reaching their goals. However, if you use a "risk tolerance" questionnaire WITHOUT the context of the client's goals, how would you know?
Well said and well recapped. This thread has been very helpful in how I frame my explanation to clients regarding the necessity of the process and its inherent limitations. Good post.
- Active RIA, Cinti, Oh
December 15, 2009 1:53:37 pm
Bob-
Thanks for sharing your opinion. We don't have enough of those in this industry.
they're no more a path to enlightenment than Monte Carlo results are an assuredness of success.
One of the issues that I am trying to communicate is that it is not about the tool, it's about the craftsperson, and in order to be a master craftsman I need to really understand the correct use of a tool. I am afraid many of us do not take the time to understand the correct use of the powerful tools we are using.
- Carl Richards, US
December 15, 2009 9:22:41 am
I've never been a fan of RTQ. As in many other instances in our profession, the CYA factor is problematic. Are we really CYA if a client runs out of money but implicitly understood the definition of STD DEV? I think not. Also, for all the investment theory that gets bantered about, the term bias tends to often get overlooked. Were one to think that the current environment doesn't impact how folks might answer a RTQ then I think we're understating the facts. To my way of thinking, I believe that investment portfolios should be segregated by goals and that those goals and the clients willingness/ability to meet them are the governing factor. The emotional context of here's your goal and you either get there or you don't is an empowering factor. What's the risk of not achieving the goal? Are you willing to accept a higher probability of loss in order to meet it? Will you increase funding to retain the probability estimate and then be able to reach the goal? I'll submit that if behavioral finance has taught us anything it's not to ask a client in the Summer of 2008 how much money that they want to put in stocks...at least if you're expecting a straight answer. I do believe that RTQ's shed light on where we need to educate clients but they're no more a path to enlightenment than Monte Carlo results are an assuredness of success.
- Bob , New Jersey
December 14, 2009 3:41:19 pm
@ScottNeal- Thanks for mentioning Finametrica and that study. I too found that amazing. I would imagine if you completed the same experiment using the CYA questionnaire that are so popular with the pick-a-portfolio folks you would NOT see a risk tolerance stay stable.
- Carl Richards, US
December 12, 2009 3:21:44 pm
Mr. Neal, if I understand your central points then we are in complete agreement. My experience over the years is that those clients we have beaten over the head at the intake with the RTQ and related volatility realities, and who nevertheless agreed to Buy and Hold / Structured / Traditional portfolios are still with us today. Most were not happy after 01-02 but some stayed the course. After Wreck of 08 all of those clients have now embraced Tactical Asset Allocation.
So, the RTQ served its CYA purpose and proved to be all too true a predictor of reality. Imho, our job now is to convey the realties of the New Normal which may make the historical math underpinning the standard dev in the RTQ's obsolete. The speed and volume of global financial tranactions, the inability of the govt to regulate Wall Street, the continuing sheer greed and ingenuity of the bad actors (GS this is you), and the changing core nature of the global markets (esp. China) means that we may have no idea where bottom and top are any more. I suggest a much more flexible and nimble strategy combined with heightened management of client expectations.
Good post.
- Active RIA, Cincinnati, OH
December 12, 2009 10:13:29 am
In a recent report by Finametrica, the writers concluded that risk tolerance has remained relatively stable even through the Wreck of '08. One of the reasons that such conclusions can be reached is because the assumption in both the typical RTQ and this study is that the only risk is volatility from the expected (the mean) the measurement of which is std dev. What you have pointed out is the need to determine first ALL the risks that the client faces before you attempt to measure and mitigate them. My 30+ years of experience can validate that you are right in that there are not many, if any, individual clients who care much about volatility. That fact alone should be sufficient to call into question the sole use of tools that aim to identify and mitigate that risk.
- ScottNeal, Lexington, KY
December 10, 2009 12:33:00 pm
Good follow up to Roger's question. Basically, the industry is bifurcated, and in the small shop world (my world) we see a constant stream of broker and bank relationships that were based almost exclusively on the RTQ. As we already hashed out, a lot of these are abysmal old-school re-prints.
In the mid to large shop arena, and with accounts over $500k, I am sure the competition naturally forces a more refined and up to date process and the situations I see regularly are fairly rare in that strata - but they still happen as I have seen multi-million dollar portfolios managed for years on outdated RTQ's only.
This remains a practice growth and differentiation point for those of us willing to do the holistic work.
- Active RIA, Cincinnati, OH
December 9, 2009 10:33:04 am
The problem is that when real people, in the real world, think about risk, I am almost positive they don't ever use the term standard deviation.
Haha. You nailed it there.
Even if we forget about risk tolerance questionnaires for a moment, using SD as a stand-in for risk is so deeply ingrained in financial academia and the financial industry that it's almost impossible to *not* use that definition in some ways, no matter how much you intend not to.
It's built into the standard way of looking at asset allocation. It's built into safe withdrawal rate studies. It's built into just about every piece of financial software I've seen (aside from a simple spreadsheet).
- Mike Piper, Chicago
December 8, 2009 4:24:56 pm
@Roger- thanks for the question, and let me clarify.
I realize that there are plenty of planners taking the time to understand a client's complete goals and use a RTQ as an educational piece within that context.
What I am taking about here is based on the proliferation of pick-a-portfolio firms that use out-dated risk tolerance questions (not the good ones we talked about last week) to build portfolios for their clients without taking the time to understand the clients unique goals.
There seems to be a lot of people out there that have made asset allocation, and portfolio design into just another product to sell without taking the time to put it in the context of a clients life.
Hope that makes sense.
- Carl Richards, US
December 8, 2009 4:05:52 pm
You seem to presume that most advisors do not look at their client's risk tolerance within the context of the client's goals. On what do you base that presumption?
- Roger Wohlner, Illinois
December 8, 2009 12:53:26 pm
A wise risk manager must manage both (his client's) stomach and wallet risk ranges, otherwise risk assessment tools don't serve the customer.
- JonathanSmith, NC
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