Tegra118 Discusses Risk Tolerance With Michael Kitces And Skip Massengill

May 12, 2020

Tegra118 Discusses Risk Tolerance With Michael Kitces And Skip Massengill

May 12, 2020

With the outbreak of the coronavirus and its impact on financial markets, it may seem like an odd time for financial advisors to consider whether clients have taken the appropriate amount of risk to reach their goals.  But that was exactly the conversation I had earlier this year with Michael Kitces, now head of planning strategy at Buckingham Wealth Partners and publisher of the Nerd’s Eye View blog for financial advisors, and Skip Massengill, founder of the Retirement Education Institute.

Since then, we have witnessed historic market volatility and record-setting point drops as the stock market collapsed, rolling back years of gains as economic activity comes to a virtual standstill and people around the world stay home. While the full range of economic impact remains to be seen, we can’t ignore the fact that the practice of financial planning has moved beyond an investments-and-liabilities mindset to a need for financial advisors to better understand their clients’ attitudes toward risk, and being aware of their physical and emotional well-being as we face the crisis. Prior to our current Covid-19 climate, advisors recognized the importance of taking a holistic, personalized approach to their clients’ finances. Particularly now, the advisor role has expanded to ‘life coach’.

Over the past decade, advancements in technology and communications have made it easier for advisors to better manage their clients’ wealth with easy-to-use digital tools that enable collaboration, can quickly assess financial health, and foster a more meaningful goals-focused discussion. Still, on a fundamentally human level, advisors need to understand a client’s risk capacity and tolerance.

Below are excerpts from my conversation with Michael Kitces and Skip Massengill on the topic of “The Boundaries of Financial Advice, When Clients Need More Risk to Reach Their Goals.”  You can also listen to the full webinar recording full webinar recording here.

Igor Jonjic: Tell us a little bit about the difference between risk tolerance and risk capacity.

Michael Kitces: This is an interesting construct that we’ve really just started to better reflect on and understand in the advisor marketplace over the past couple of years. If you think of the traditional financial advisor risk tolerance questionnaire, some questions pertain to things like What is the client’s time horizon? What is their need for income? What is their availability for assets? We would have very different investment recommendations around those just because you cannot give the same recommendation to someone who needs the money today that you would for someone who doesn’t need to touch the money for decades.

On the other side, we have those traditional questions around what I would call ‘client attitudes around risk’. The sort of traditional one is: If the market fell 25% would you A) Buy more? B) Hold? C) Sell and freak out? We try to understand how clients might react to market volatility and market declines, and then we typically mash all these together into this one number we call ‘The Client’s Risk Tolerance Scores’.  I call this a ‘one dimensional approach to risk tolerance.’ As your scores go up in either category, it pushes you out to be more and more aggressive over time. And the challenge to this is that sometimes it ignores the practical reality of what the client has said.

The question of What is your tolerance and willingness to take risk? and What is your financial capacity to take risk? are really two different dimensions on the spectrum. So, I could end up with a very conservative portfolio, either because I’ve got a lot of money and capacity to take risk, but I just don’t want to. Or, I might have a lot of tolerance to take risk and be a very aggressive investor, but I don’t have much capacity to take risk anymore because I just retired and need to draw my portfolio immediately.  When we look at this, there are really two different things that can drive clients to be more conservative: Either a limited willingness to take risk, or, a limited capacity to take risk. Even though ironically, the ‘traditional’ advisor approach would invest both of these clients aggressively – one because they’re willing to take risk (even if they can’t afford to), and the other because they have the capacity to afford to take risk (even if they don’t want to).

The reason it matters is you get these ‘mismatches’, such as  I’ve got a lot of wealth and I can afford to take risk, I just don’t want to, or, I’ve got a lot of willingness to take risk, but I can’t actually afford to take it because if something bad happens my goals are ruined. When we view risk tolerance one-dimensionally, either willingness or capacity to take risk increases the risk we recommend. When we view it two-dimensionally – where risk tolerance and capacity are independent constraints – we reach the opposite conclusion. Thus why the crucial starting point is you have to separate these.  Once you do, you find these mismatches in clients. And these are the clients who tend to start calling when markets get volatile… because when markets are scary, their incapacity or unwillingness to take risk becomes the controlling factor that drives their behavior and desire to sell.

Igor Jonjic:  We are trying to address this dilemma in our software by not letting the scoring from the risk questionnaire guide the decision on which portfolio should be used to achieve the client’s goal. Delineate between assessing risk tolerance, versus what objective should be used to achieve the goal.

Michael Kitces: Absolutely. The secondary piece that goes with this is that classic question: Mr. or Mrs. client, how do you feel about risky investment stuff? Are you okay if the market goes down for a while, because it should bounce back later, or is it that you just don’t want to take that rollercoaster ride? Some clients do, and some clients don’t.

This dimension of the ‘goal risk and return requirements’ embedded in capacity for risk really creates problems for clients. When you get someone who says: I would like to retire immediately at a 6% withdrawal rate. Even though this is a really risky goal, I’m an ultra-conservative investor, and I don’t want to take any risk. So come up with a solution Mr. or Mrs. advisor. And we’re sitting there thinking: This is a problem. You have a high need for risk and a low tolerance for risk. What am I supposed to do now?

Igor Jonjic:  Should we change the questionnaire depending upon the client’s age or lifecycle? Or should we focus more on behavioral questions? How do we assess somebody’s risk?

Michael Kitces: I don’t think the actual questions about how to assess risk change. You either like the roller coaster of taking more risk to pursue better outcomes, or you don’t. We express this in our portfolios. We express this in our lives. Some people are fine driving 80 mph in a 65 mile mph zone, and others are just not willing to take the risk of a speeding ticket and are just going to drive 65 in a 65.  Some people pick very risky careers and some very stable conservative careers. These preferences, frankly, go beyond just what happens in our portfolios. It’s a question of Do I like pursuing riskier outcomes in the hopes that something turns out better given the risk that it could turn out worse?

However, the particular goals process and the financial planning end of the conversation – What are your goals? What are you trying to achieve? – looks a little different, and ultimately, drives how much risk you will need to take to get there. The actual analysis that I am going to run for a 65-year old retiree is very different than a 35-year old who still has 35 years left of accumulation. But goals are still going to tie up to some level or risk need and return, and all of it is going to tie up to some fundamental willingness that you do or don’t have to take risky tradeoffs. To me those pieces really don’t change across different client types.

Skip Massengill: I tend to agree. It just depends at what point in their lives are they becoming a client or maintaining that relationship, or what has happened in their lives that might have changed that.

We have to think about it in terms of governance. From a legal standpoint, we’re going to go out there and do the right thing.  The next step is fiduciary. How well did you do what you are legally bound to do? The next step is stewardship. How are we communicating with the client, and how am I implementing the discussion and the questions with empathy and understanding what they are saying back to me?

To Michael’s point at the beginning of this call, do we as advisors, really understand what we are being told, and are we working with our clients? If you do all those things you can be a great leader. And that’s what your clients are looking for. Your clients are looking for how we as advisors lead them. But we can only lead them if we understand them and we can help them make decisions within their goals and objectives that are realistic.

Perspective - July 27, 2020

Retirement Income: Enriching Advisor-Investor Conversations with Technology

The conversation about retirement is changing and redefining financial planning. Market volatility has highlighted the need for safe and secure lifetime income. With millions of baby boomers retiring and seeking to preserve and stretch their nest eggs, advisors and investors can benefit from collaborative discussions that address their long-term income needs in the post-pandemic era. In this LinkedIn Live conversation, industry influencer April Rudin sits with Tegra118’s Rich Keltner, Director of Product Management and Michael Roth, Head of Retirement to discuss how technology is making it easier to solve for clients’ retirement and lifetime income.