Paul Resnik says now is the time to pro-actively work with your clients to personalise your service.
The importance of your considered advice has probably never been so high.
We have brought together what we know from the world of behavioural finance and our own research to suggest how you can best review client portfolios in themselves, better match those portfolios to client needs and, in the process, help clients take responsibility for their financial plans.
Research perspectives and understanding of client’s financial risk tolerance
These are some of the important things that we know:
1. Individuals view losses asymmetrically to gains. That means that they fear potential losses more than they relish potential gains. Kahneman and Tversky behavioural finance research suggests that the ratio may be 2:1. The pain an investor experiences in losing a dollar is twice as powerful as the satisfaction experienced in earning a dollar.
2. FinaMetrica data confirms that women with the same demographic characteristics as males on average have a lower financial risk tolerance. They are more afraid of the consequences of financial losses than their male counterparts. Partners in couples are almost invariably different.
3. Recent research from the University of Southern Queensland has confirmed that financial risk tolerance is an identifiable trait that does not alter with changes in consumer sentiment.
4. Research from Monash University suggests that there is a strong link between risk tolerance and risk taking in a real world lottery experiment. Those with a higher risk tolerance were prepared to take on more risky plays, while those with lower risk tolerances were much more conservative in their bets.
5. If you make personal assessments of a client’s financial risk tolerance you should be aware that FinaMetrica research identified that financial planners, even with clients that they know well, assessed their clients’ risk tolerance inaccurately. One in six assessments was wrong by two standard deviations or more. There was no pattern of difference; some were overestimated, others underestimated.
6. Academic research shows that the vast majority of risk-profiling questionnaires are both dangerous and inherently flawed. They conflate risk needed to achieve goals with risk tolerance to generate a recommended portfolio and in so doing depersonalise the most important decision an investor needs to make: how much risk they accept in their financial plan. The major consequence is that when markets turn sour, many who used “portfolio pickers” are somewhat more likely to sell out of growth assets. They may then have only a limited chance of re-entering the markets at an appropriate time.
Those who use a “portfolio picker” questionnaire to recommend portfolios have only a limited understanding of a client’s underlying financial risk tolerance at best.
If you have clients who are a couple, you probably have neither an explicable nor a defensible method to account for each person’s separate risk tolerance. In both cases, you are unlikely to have a clear acknowledgment from them about the risk they have taken on in accepting your recommendations. In most cases you will be taking on all of the liability for the financial risk, not the client.
A scientific risk assessment, on the other hand, can be structured as an instruction to you from your client on the amount of risk they are prepared to take.
Review clients and their portfolios now
It is not too late to bring in clients to review their circumstances and re-assess their needs, including helping them understand their financial risk tolerance(s), how it impacts their financial plan and how it compares to the riskiness of their portfolio.
Whether or not they originally undertook a FinaMetrica risk tolerance assessment, another psychometric risk assessment, a simple portfolio picker, or even if no risk profile was undertaken, a simple invitation to revisit their risk tolerance in light of their circumstances, their portfolio and the state of the markets may be the most credible offer they will receive today. Here are seven common sense things you might do:
• Review portfolios as if they were in cash. Would you make the same investments now? If not, develop a plan to move the money. Consider selling on any “dead cat” bounce.
• Review leveraged assets and asset classes. Apply the 10-minute bin test. If you do not understand it in that time, it could be appropriate to move on.
• It might be prudent to reduce specific company risk but retain market risk through exposure to indexes and exchange traded funds (ETFs).
• It might be time to review the level and scope of portfolio diversification. Remember cash is an asset class.
• Seek to minimise cost, tax and transaction inefficiencies through better selection of investment vehicles and wraps.
• It might also be worth considering putting low-risk-tolerance individuals into structures that minimise their downside experiences. So, if you are running direct equities, make sure you know which clients are more likely to stress out and cash out.
• Similarly, for those who currently own volatile individual managed funds that might induce an anxiety attack, a fund of funds could be a better solution.
It makes good sense to shield lower-risk-tolerance investors from multiple negative experiences. Any portfolio of direct holdings in shares will generate significantly more bad experiences than a similar equity exposure in a managed fund. Having the equity exposure through a series of managed funds will generate a lower number of losses. Utilising a “fund of funds” limits the bad experiences even more. So, without diminishing equity exposure, risk-averse investors can participate more easily in markets most likely to deliver the portfolio outcomes needed.
Justifying your ongoing relationship by matching needs to products
You need to justify the fees for an ongoing service that ordinarily deals with the rich complexity of changing personal circumstances, needs, investment markets, legislation and economic conditions. You need to generate a real long-term financial plan that identifies the client’s goals and aspirations mapped against their resources.
The critical trade-offs between risks needed to achieve those goals, along with the spending and financial risk taken on, will need to be illustrated to (and be seen by) the client in order to form the core of the ongoing client relationship.
It is only with this that there will be a solid basis for both client ownership of the plan and an ongoing service relationship. Both planner and client will have a clear understanding of their role and their accountability. Without this, there is only transactional advice, from which there is no basis for either an ongoing service or a recurring fee.
The critical issue is the full recognition of the client’s individual needs, circumstances and aspirations. Recommendations can consequently be easily seen to be matched to the requirements of the client. The personal circumstances to be addressed include:
• Recognition of the client’s needs that have a financial dimension. For instance, a new car in 2010 with specific costs, living costs etc;
• Recognition of the client’s longevity. Taking into account the difference between partners. In traditional couples the female may live 10 or 15 years longer than the male;
• Projections of net assets and outgoing expenditure to at least 15 years beyond the client’s (and partner’s) life expectancy;
• Recognition of the client’s (and any partner’s) financial risk tolerance and how any difference in financial risk tolerance between the partners is resolved;
• Recognition of how risk tolerance is accounted for in the plan;
• Description of how the asset allocation recommendation was arrived at;
• Illustration of possible volatility in the recommended portfolio;
• Quantification of the range of possible portfolio outcomes;
• Recognition of the client’s risk capacity; and
• Meaningful identification of how the manager recommendations were arrived at.
Consequently, a properly structured financial plan will do much to share responsibility with the client for the decision-making. In addition, there will be an obvious pathway for the client to take ownership of the recommendations based on their “properly informed commitment” to the plan.
Clearly, a “living” financial plan needs to be regularly monitored for changes in client circumstances, economic conditions, government legislation and the broad range of issues that impact upon the client’s financial wellbeing. Justification for ongoing financial planning fees clearly follows.
Your clients need you to help them through this challenging stage of the economic cycle.
There are two things that most financial services players agree on: losing money makes clients unhappy and everyone, industry insiders and clients alike, becomes upset when expectations are not met. So it’s best to manage both clients and expectations pro-actively. The bottom line is to minimise the likelihood of a client bailing out of the market and feeling entitled to blame you, their financial planner, for any crystallised losses.
