When Clients “Need” More Risk Than They Can Tolerate: Adjusting Portfolios, Or Goals?

It is a standard requirement in financial services that financial advisors must first determine an investor’s risk tolerance before making any investment recommendations for their portfolio. Yet in the modern era, good financial advisors don’t just invest a portfolio for growth or preservation of principal alone, but to achieve the investor’s goals, and whatever required return (and associated risk) those goals necessitate. Except in practice, doing so is sometimes impossible – because not all investors are able to tolerate the amount of risk they need in order to achieve their goals in the first place!

For financial advisors, this leads to two alternative paths for implementation. The first is to take a more “authoritative” approach, where the financial advisor is literally “the authority” – the expert – whose job is to implement whatever the investor needs to achieve the goal (i.e., to invest them for what they need, regardless of their tolerance), and then bears the responsibility to help their clients stick with the plan and stay the course (i.e., “behaviorally manage”) through the inevitable market downturn. By contrast, the second option is a more “accommodative” approach, where the financial advisor may educate and make suggestions to the investor about why they need (and should be more comfortable with) a greater level of risk, but in the end accommodate however the client wishes to invest (since it’s their money and their decision in the end, even if it’s a path inevitably doomed to failure by generating insufficient returns).

On the other hand, arguably the real problem is not just about deciding whether to be more authoritative or accommodative with respect to an investor’s mismatch between their need for risk and tolerance to take it, but recognizing that their need for risk is so (problematically) high because their goal itself is very demanding and risky in the first place. Which means the best path forward may not be about trying to determine the “optimal” portfolio at all (because there really isn’t one) but is instead about helping clients to adjust their goals such that they don’t need more risk than they can tolerate in the first place. In other words, the advisor doesn’t need to be authoritative or accommodating of the client’s high-risk-need and low tolerance if the goals can be adjusted so the client no longer has that high-risk need after all!

Or stated more simply, in a world where portfolios aren’t just invested for growth or preservation of principal in the abstract, but specifically to achieve certain goals, the first step of the process is not to align the portfolio to the client’s risk tolerance, but to align the goals (and the amount of risk they would necessitate) to the client’s risk tolerance in the first place. Because once goals themselves are aligned to risk tolerance… implementing the optimal portfolio turns out to be remarkably straightforward!

This is the Executive Summary of Michael’s blog. Read the full article here.

This article summary has been reproduced with permission from Michael Kitces at Kitces.com. ©Michael Kitces

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