Astron building  Alaba Intl mkt Lagos

Astron building Alaba Intl mkt Lagos

A Comparison of Risk Tolerance Products

A Comparison of Risk Tolerance Products

Bear markets beget portfolio losses, unhappy clients and, sadly, lawsuits against advisors. If you relied on any of the popular risk tolerance products to construct that portfolio, here’s how you are likely to fare under the careful scrutiny of an arbitrator.

Some alert readers may have noticed that the markets experienced a sickening 30% drop over approximately a month, from February 20 through March 23. Yes, the markets have recovered somewhat since then, and yes, most diversified portfolios were not quite so hard hit as that figure implies. But by the same token, I don’t think any of us believe that the gyrations, especially on the downside, are over quite yet.

The really good news here is that, since the 2007-9 debacle, many advisory firms have started using sophisticated risk tolerance instruments with their clients. These instruments help them to co-create portfolios that clients would be comfortable with even in a storm like the one we’re experiencing. Our most recent T3/Inside Information Software Survey Report (available here) found that more than 41% of respondents are using one of the 11 software tools that we identified. The actual percentage is probably higher, since we did not include programs like AdvisoryWorld (built into many BD platforms) that allow advisors to create their own customized risk tolerance quizzes, and Andes Wealth (see below), which is a portfolio analysis tool with a risk tolerance component built into the front end.

The best practice is to use a scientifically-valid measuring tool to not only explore client psychology, but also to facilitate a deeper conversation about each client’s comfort with downside volatility. For anxious clients, you know to dial back the exposure to risk-based assets. And the risk tolerance exercise lets you identify the clients who are most likely to engage in panicked selling, so you know who to contact whenever the markets fall 10% in a single day.

But of course this process is not perfect.

Bear markets are associated with an uptick in lawsuits and arbitration claims. No matter how well you prepare your clients, there may be one or two who will blame you for their market losses, and ask an arbitration panel to reach into your pocket and make them whole.

The question becomes: How confident are you in the scientific validation of the risk tolerance instrument you used? How well would you be able to defend the program you used against the sharp questioning of an astute plaintiff’s attorney?

To find out, I asked each of the leading risk tolerance companies to provide me with the scientific justification for their assessments. This is what I found.