As an industry, we have diligently developed methods to understand our clients’ risk tolerance; yet, we have misapplied this information. This can be serious and requires immediate correction.
Before we fix this problem, let’s explore risk tolerance and its application. Let’s call risk tolerance financial attitude, or how a person feels about any particular financial undertaking. There are two key elements or issues surrounding a person’s financial attitude: To what degree does the person understand what is involved, and how is he or she reacting to that understanding?
There are many types of risk, as the list below reveals. Nonetheless, we are not addressing any of these risks in this month’s column. Instead, we will explore how clients react to each of these risks, which is real, or how people think they will react, which is perceived.
Are you committing malpractice by recommending products that don’t allow clients to meet their goals?
Consider this analogy: A five-year-old enters his mother’s closet to explore its contents. A gust of wind blows the closet door shut. One moment, there is plenty of light to explore nonthreatening clothes. The next moment, it’s totally dark and scary. The closet’s contents did not change. The only thing that changed was the lighting, which provided the child with a sense of perceived safety. The situation could be remedied by merely turning on the closet light.
I’ve found that when I turn on the light—that is, when I provide clients with information to help develop their knowledge—their fears are reduced or eliminated. As trusted financial advisors, our job is to evaluate our clients’ understanding of how insurance and investments work. Next, we need to provide information on anti-risk techniques for the low risk taker, or conversely, to explain to aggressive risk takers the dangers of excessive risk taking.
Let us divide this planning process into manageable steps: First, discover your client’s risk tolerance level. Our industry has developed many questionnaires to help you evaluate this status.
Second, properly apply this information when recommending financial products and services. This is where our industry has missed the boat. Actually, it is more disastrous than just missing the boat—it is more like "torpedoing" the value of the evaluation.
Insurance companies, investment product providers and even our educational institutions have promulgated the use of a tolerance scale to recommend only products that match the risk level a client scores in the evaluation. If you follow this scale, you are a victim of improper training.
Why? Because the tolerance level a client scores tells you how the client perceives his or her comfort level to be. It also indicates your client’s knowledge level of the proposed financial strategy. It does not indicate, however, what products and services are needed to achieve your client’s goals. While it won’t tell you to recommend one product or the other, it does tell you to what extent you will need to provide information, and sometimes, how long it will take the client to get to the point at which he or she can tolerate the needed "medicine."
My partner, Mark Davis, explains it as follows: When a medical doctor diagnoses a patient’s condition, the doctor prescribes the proper remedy. If a patient states that he does not like the taste of a certain medicine, the doctor doesn’t obligingly say: "In that case, I will only give you half a dose. That would be less offensive." But, that is malpractice.
Instead, the doctor might say: "Yes, the taste is strong, but there is no better cure. If you take a mint following each dose, it might be more tolerable. If I reduce the dosage, you may not recover."
Are you committing malpractice by recommending products or services that do not allow your clients to meet their financial goals or are you providing only halfway measures?
If your client has a low risk tolerance score, it’s not necessarily permanent. It should tell you that time is needed to educate this client about "how it works." Turn on the "light," or prescribe the right "medicine." Easier-to-swallow alternatives probably will not do the job.
If your client is a very aggressive risk taker, the same thing applies. Take the time to educate him. Describe how excessive risk taking is not worth the small potential extra reward.
Donald Ray Haas, CLU, ChFC, CFP, MSFS, of Southfield, Mich., has been an insurance agent and financial consultant for 45 years. He can be reached at 248-213-0101 or at Donaldhaas@aol.com.