If you know a client’s attitude about taking risks, you’ve gleaned valuable information in the investment advisory process. A risk tolerance questionnaire, however, provides only a starting point to fully understanding a client’s real level of investment knowledge. It can take me up to two years to significantly understand my clients’ attitudes. But if I wait for two years before offering any recommendations, my clients would find another financial advisor to serve their needs more expediently. Therefore, we need to find out as much as possible about our clients within a limited period.
The Financial Attitude Questionnaire described in the February 2002 column helps put financial advisors on an accelerated path toward a better understanding of their clients’ risk tolerance, as well as their level of understanding of insurance and investments. Let’s take a more in-depth look at the questionnaire’s meaning and typical client responses.
The first question is to ask clients to grade how they feel about placing their money in each of the 10 investment vehicles. I prefer administering the questionnaire myself so I can study my clients’ reactions and hear their inquiries firsthand, rather than leaving this task to my staff. For example, after an uncomfortable silence, one client looked up and said, “I don’t know anything about these investment options.” This significant lack of investment knowledge was embarrassing for my client. I responded with, “Then, let’s discuss each of these investment vehicles until you become more comfortable. The first place you can invest—a savings account—is simply a bank account that pays you interest on your deposits.” My client replied, “I know that one, but not any of the others.”
“That’s fine,” I encouraged. “Let’s explore the other categories.” As we proceeded, I began to notice that my client’s initial embarrassment had disappeared. The fact that he did not understand the second category, or the cash value of life insurance, indicated that he was unfamiliar with this type of insurance. It also signaled to me that I had to educate him about life insurance’s role in a balanced portfolio.
Clients who are less sophisticated frequently ask, “What’s a corporate bond?” That gives me an opportunity to describe stocks and bonds, which almost everyone has heard of, but does not necessarily know about the term “corporate” bond. This query could mean the clients have a low level of investment knowledge or simply do not recognize financial services terminology. In either case, it is insightful.
While most clients know about mutual funds, many are not familiar with variable annuities; as a result, I spend time describing the similarities and differences between these investment options.
Addressing other questions
The second question tells us to what degree the fear of loss vs. the joy of gain could affect a client’s motivation to proceed with certain investments. When your client’s fear of loss is overriding, no amount of gain will overcome that phobia until you, as the professional advisor, develop methods to reduce this fear.
Question three helps you quantify the perceived risk level clients feel they can tolerate. If they feel none at all, they’ll usually respond with a no. If they answer this question’s second part with a very high percentage rating—50 percent or higher, which might validate an overall score of 18 or more—watch them closely. A high score indicates they’re overly aggressive and may make an imprudent move without conferring with you.
Question four provides important information in two areas: first, your clients’ knowledge level of the seven items and the level of their concern for each (prioritization). It also shows how clients’ priorities help the advisor validate the entire questionnaire’s score.
When any of the following three conservative responses—liquidity, current income, or safety of principal—are rated the most important, the clients’ total scores are usually quite low. If the total score is not low, then further exploration is needed. For example, if their total score is 17 on a scale of 23 and current income is a top priority, look closely at the level and stability of actual income. Maybe the concern is simply a manifestation of the immediacy. Just fixing the current cash flow and balancing income and outflow could alleviate this concern or reduce its importance. This would produce a more accurate evaluation of your client’s real risk tolerance.
Know your customer
This financial planning tool will not provide the whole story about a client’s profile and it is still imperative for you to “know thy customer.” In fact, as a professional financial advisor, it is your ethical responsibility to gain the most complete understanding of each client’s attitudes, educate and answer questions, and disclose any pertinent investment information before you make any recommendations.
Donald Ray Haas, CLU, ChFC, CFP, MSFS, of Southfield, Mich., can be reached at 248-212-0101 or at email@example.com.