A New Way to Know Your Wealth Management Clients
It’s important for financial advisors to pursue a complete picture of their clients. However, this is not always as simple as it sounds. The typical industry standard is only to be concerned about whether or not your clients are doing better than the market average or if they’re still on track to meet the client’s long term goals. Now, these are excellent questions, of course, but they don’t even begin to approach any stress or concerns regarding financial market risk.
When most advisors are asked about risk, they quote CAPM or the Sharp ratios and other stat measurements. Rarely, if ever, does an advisor attempt to ascertain if overall risk (i.e. volatility) in their client’s portfolios is appropriate. The majority are convinced that if the sharp is high and, returns are better than the market benchmark; it’s all ok.
This is not ok.
It’s important to know that in the investment markets, volatility cuts both ways. It’s great on the upside, but volatility is treacherous when markets are down. Stress goes up when markets go down…and stress can mess up someone’s life.
There’s no real way to test for stress in a person, other than cortisol tests for the physical aspect. We cannot eliminate stress. However, financial advisors most certainly test clients for their risk-taking capacity. Wealth management is part behavioral finances, and advisors can…and should test clients to assess how much risk they inherently take with their everyday lives. If advisors strive to keep clients below their risk threshold, that’s how the industry can better manage client stress—making their lives better.
If a client has $1M in their portfolio, and a financial planner asks if they can handle a 30% loss, the client will most likely answer in the affirmative. However, reframing the question to ask if they can tolerate a loss of $300,000 may cause the client to be less assured—a percentage loss is abstract when it’s compared to an actual dollar loss. Stick to dollar amounts for a more accurate risk analysis of your clients.
Recency bias can also become an issue—this asserts that the decision makers focus on the most recent data to make decisions. If the question asked is framed as a 30% loss during a time where stock and bond markets have been up—like during the recent bull market, the probability that a client will say they can tolerate a 30% loss will go up. Roaring markets provide the consensus that often comes to the conclusion that rallies will continue. This translates into confidence in clients that big losses have a low probability of occurring.
To strengthen value to clients, and relationships with them, behavioral finance processes must be employed.