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The Risk Score Isn ’ t Everything
There ’ s a better way to construct portfolios than scoring risk tolerance . By James Montier , Martin Tarlie and Matt Kadnar
FOR TOO LONG , FINANCIAL ADVISORS HAVE BEEN making asset allocation decisions for their clients according to a “ risk score ,” a figure developed around client questionnaires to determine how much risk they can tolerate . But this approach often results in portfolios that are disconnected from actual client goals and are unresponsive to changes in clients ’ financial situations . As a result , investors are not receiving truly personalized portfolios . That leads them to sub-optimal outcomes — and a much bigger risk that they won ’ t meet their goals .
In our research , we ’ ve gathered evidence for and become advocates of something different — an “ investment policy process ,” that balances the crucial elements of a client ’ s time horizon , risk tolerance , cash flows and return objectives , using them to create a dynamic , ongoing strategy that adapts in real time to their changing lives and market conditions .
Risk Scores Dominate Everything
According to the CFA Institute , an investment policy statement should be “ a written document that clearly sets out a client ’ s return objectives and risk tolerance over [ their ] relevant time horizon , along with applicable constraints such as liquidity needs , tax considerations , regulatory requirement and unique circumstances .” The three pillars of the clients ’ investments , then , are their required rate of return , risk tolerance and time horizon .
Yet when it comes to financial planning and building a client ’ s portfolio , pretty much one component dominates everything : risk tolerance ! Both the required rate of return and the time horizon are treated , at best , as poor distant cousins in the discussion or at worst banished like Harry Potter to a closet under the stairs . The complexities of the client ’ s life get boiled down to a single number : the dreaded risk score , which ends up being virtually the exclusive determinant of their asset allocation , and arguably one of their portfolio ’ s most important characteristics .
The Dangers Of Relying Too Much On A Risk Score
On the surface , boiling a client ’ s risk tolerance down to a risk score may seem alluring . It ’ s easy to both understand and communicate . But it also fails to take into account the nuances of a client ’ s needs and circumstances . Using a risk score to build a client portfolio essentially nullifies an advisor ’ s great financial planning , throwing all that work out the window . The result-
JULY / AUGUST 2024 | FINANCIAL ADVISOR MAGAZINE | 45