Any investor who has ever engaged the services of an advisor is likely familiar with the various risk questionnaires that have become a standard part of the client onboarding process. In part spurred by regulatory considerations, determining a client’s attitudes about risk (and likely reactions to subpar investment results) has become a central goal of the initial client interview process.
Of course, as I’ve examined here before, that process itself is fraught with difficulties and uncertainty. Among other fundamental issues, investors are notoriously unreliable at reporting their own risk tolerance, often overstating their level of comfort with investments that carry above-average risk. That dynamic is consistent with findings in other areas of consumer psychology, in which self-reported survey results almost always need to be discounted or adjusted in some form or another.
Furthermore, investors often conflate or confuse risk tolerance (the psychological response to risks) with risk capacity (the ability of a financial plan or portfolio approach to withstand negative outcomes). Just because an individual has a tendency toward risk-seeking behaviors does not mean that they need to be (or should be) taking outsized risks with their investment portfolio; in fact, the opposite is often true.
These issues are certainly important ones, and worthy of our discussion and consideration. And yet, a recent study raises a related—but much more infrequently discussed—question. Even in situations in which the advisor may be doing a very good job of assessing the risk tolerance of the client, the client may not be doing a good enough job of doing the same in reverse, thus creating a potential mismatch between investor goals and advisor strategies.
A recent collaborative paper shared by Marginal Revolution’s Tyler Cowen revealed one (admittedly simplistic) factor that could speak volumes about the likely investment approach of investment advisors. The authors wrote:
We find that hedge fund managers who own powerful sports cars take on more investment risk. Conversely, managers who own practical but unexciting cars take on less investment risk. The incremental risk taking by performance car buyers does not translate to higher returns. Consequently, they deliver lower Sharpe ratios than do car buyers who eschew performance. In addition, performance car owners are more likely to terminate their funds, engage in fraudulent behavior, load up on non-index stocks, exhibit lower R-squareds with respect to systematic factors, and succumb to overconfidence. We consider several alternative explanations and conclude that manager revealed preference in the automobile market captures the personality trait of sensation seeking, which in turn drives manager behavior in the investment arena.
Is it possible that hedge fund managers are unique animals, and that this sort of analysis is irrelevant when considering traditional portfolio managers and RIA-type firms?
Sure, but the findings nevertheless beg the question: are we as investors doing enough, on average, to learn about and investigate our advisors’ investment approaches and risk tolerances? Is it possible that an advisor’s own approach to risk management could override the findings of a client risk questionnaire, such that the advisor could end up taking more or less risk than the client actually desires?
It seems as though there is significant room for the “risk tolerance” conversation to become more of a two-way street. Instead of merely determining the client’s risk tolerance and then assuming that the advisor is capable of executing on the client’s risk profile wishes, a reciprocal conversation that attempts to find a match between the two parties’ risk profiles could be more fruitful and successful.
Of course, the usual caveats apply: if we’re unable to reliably assess investor risk in the initial client interview, why would the client have any better of a chance of accurately assessing the risk stance of the advisor? And yet, the client is in a much stronger position to successfully complete that interview than an advisor would be in the other direction—a prospective client can ask to see information regarding investment philosophies, study sample portfolios, ask for client references, and even ask about specific securities that would be owned in advance of establishing an advisory relationship.
From the perspective of the advisor, there is simply no reason not to provide this kind of information. In fact, it is completely in the advisor’s interest to ensure that clients are on the same page, and that they have proper expectations of the portfolio approach that is going to be utilized. Philosophical mismatches typically yield subpar client experiences, and unhappy clients rarely remain clients for long (they are also, of course, unlikely to refer other potential clients).
Particularly as we enter into an era of increased fiduciary responsibility (one way or another; stay tuned for more), both advisors and clients should be shifting their focus to a new paradigm in the risk assessment arena. Clients should not blindly assume that advisors can execute in a manner that is consistent with their goals and desires, nor should advisors want to take on clients who are likely to be unhappy with their investment performance (or approach) over the long run.
The more two-way work that can be done to play “matchmaker” on the front end, the more fruitful the advisor-client relationship is likely to be. And if all else fails, investors might want to take a peek into their advisor’s garage—it may be holding valuable information about their investing future.