I Take Issue With the Entire Concept of Using "Risk Tolerance" To Determine Asset Allocation

I often see mutual fund complexes, and some "robot-advisors," state that an investor's portfolio should be determined by his, her (or their) "risk tolerance."

Often one's "risk tolerance" is done via a questionnaire. Some risk tolerance questionnaires are only 10 or so questions long, while others have many more questions.

One risk tolerance questionnaire, from a mutual fund company, contains this disclosure, in pertinent part: "This tool will produce a recommendation for an investment portfolio comprising only mutual funds and no other investment products. You can use this tool to help you determine an asset allocation (the percentages of your identified assets you invest in stocks, bonds, and short-term reserves) and an investment for your mutual fund account that may best suit your goals. After you answer the questions, this tool will provide a suggested asset allocation and a recommendation for one or more _______ funds that target that allocation ...You are under no obligation to accept the suggestions provided by this tool. The recommendations provided are based on generally accepted investment principles."

I take issue with a couple of these statements. I don't believe that an online tool such as this will produce an asset allocation "that will best suit your goals." Nor do I concur with the statement that the recommendations resulting are "based on generally accepted investment principles." The first statement is false, and the second statement is overly broad and likely misleading.

Why not use such online tools? Because such simple tools don't take into account an investor's NEED to take on risk. Depending upon a great many individual facts, a person's (or couple's) circumstances may dictate a much higher need to take or risk.

Alternatively, a person may have a very small need to take on various types of investment risks. For example, a client with a very large net worth, relative to future needs, may need little or no exposure to investment risks. As author William Bernstein has stated, “if you’ve won the game, why keep playing?”

Additionally, much research demonstrates that an investor's responses to at least some of the questions posed will vary depending upon the investor's recent investment experience. For example, an investor with a recent poor investment experience may have a lower "risk tolerance" per such a questionnaire. We are all emotional beings, not perfectly rational one.

Also, seldom undertaken is education to the investor about future expected returns. For example, given depressed valuations at the time (by nearly any measure), expected returns on equities were quite high in early 2009, and knowledge of this fact would have likely greatly influenced a person's asset allocation decision.

While risk tolerance questionnaires may lead to insights, that can point to the need to further discuss investment concepts or an asset allocation, especially where a substantial disparity exists between the results of the questionnaire the the strategic asset allocation adopted.

But, a well-formulated asset allocation is based on risk need and desires, relating to future specific goals the client desires to accomplish. The entire concept of using a person's "risk tolerance" to determine (or suggest) an asset allocation is highly suspect.

The asset allocation decision is often said to be the most important decision an investor will make. In my mind, the decision should be undertaken with great care, as well. And this requires a much more comprehensive review of a person's financial situation than risk tolerance questionnaires provide.

If we are to become a true profession, I believe it is time we more aggressively push back on the use of risk tolerance questionnaires, alone, to determine (or even suggest) strategic asset allocations.

I go further, and state my conclusion, applied to any investment adviser or financial advisor bound by a fiduciary standard of conduct: The use of risk tolerance questionnaires, alone and not without much more gathering of facts and goals and analysis, is in my opinion neither "prudent" nor meeting the standard of due care any fiduciary advisor should provide.

UPDATE: On April 2, 2016, Mass.Securities Division Warned Robo-Advisers to Comply With Their Fiduciary Dues

UPDATE:  In mid-March 2016 FINRA issued its own report on digital advice platforms, and their compliance with FINRA's weak "suitability" standard. In several rare moments for me (since I hardly agree with FINRA on anything they do), I found myself agreeing with FINRA on some of their observations.

Here are my observations about FINRA's report:


Generally

FINRA’s Report adds to the knowledge base regarding the use of digital advice platforms, and exposes some of their limitations. Hopefully FINRA’s Report will inform various “robo-advisors” that the use of digital technology has not evolved, as of this point in time, sufficiently to incorporate all of the factors that must be taken into account before recommendations can be undertaken as to the proper use of a client’s funds. Human interaction at key points in the decision-making process appears to be altogether necessary.

However, FINRA’s conclusions appear inadequate in describing broker-dealer’s obligations, at least in situations where the broker-dealer and its registered representative are subject to the fiduciary standard of conduct.

Proper Use of Funds Available for Investment.

FINRA’s report correctly notes that “[a] threshold question for individuals considering opening an investment account is whether investing is an appropriate step. In some cases, they may be better served by paying off debt or saving.” [Emphasis added.] In FINRA’s survey of firms, there seemed to be little indication that broker-dealer firms using digital advisory tools were addressing this “threshold question” adequately.

• [It is interesting to see FINRA note this, considering that I have rarely seen brokers advise clients to pay down high-interest debt, rather than invest.]

Nor did the Report indicate that advice was provided on how tax savings could result from deployment of cash for investing into the right kind of account – such as qualified tax-deferred account [e.g., 401(k) or traditional IRA] or tax-free account [e.g., Roth IRA], as opposed to investing in a taxable or non-qualified account.

• Is there any doubt that financial advice, at least at a certain level, is a prerequisite for good investment advice?

Certainly a broker-dealer and its registered representative, when acting in a fiduciary capacity, possess the obligation to advise properly on how to minimize, over the long term, the tax drag on investment returns. Hence, advice should be provided in each client’s situation as to the use of the types of accounts afforded by tax law. Given the importance of the correct choice of account for the use of funds, from a tax perspective, this fiduciary duty should not be waivable by the client nor disclaimable by the advisor.

FINRA’s report does note that a financial professional should likely be involved in the decision-making process. The Report states: "An effective practice is for firms to ask questions that would determine if an individual’s advice needs cannot adequately be met solely through a digital approach. For example, a purely digital tool might not have the capability to provide a client who wishes to manage multiple investment accounts and multiple investment objectives on an integrated basis. In those instances, the client could be referred to a financial professional as part of the advice process."

FINRA does note that registered representatives “cannot rely on the [digital advice] tool for the requisite knowledge about the … customer necessary to make a suitable recommendation.” This seems to recognize that  digital advice tools, in their current state of evolution, are just that – tools, that should be an aid in the decision-making process, and that human involvement in providing advice about certain portfolio decisions, such as asset allocation, is still necessary.

FINRA also notes, with regard to tax loss harvesting, that the use of algorithms may result in unusable realized losses, and suggests that a “full view of [a client’s] portfolio” is necessary to ascertain if the tool should be utilized. Certainly there are times, such as the presence of large long-term capital gains or other tax preference items in certain years triggering AMT, in which tax loss harvesting might be more aggressive, or less aggressive (or in which tax-free income may be eschewed in favor of taxable income, or in which taxable income is accelerated). This requires an ongoing knowledge of the client’s present and projected future tax circumstances, which is far beyond what nearly all digital advice platforms are capable of at present.

Lack of Human Interaction on Important Decisions Appears Problematic.

FINRA’s report (p.6) notes that there exist “purely digital client-facing tools” in which “financial advisors are not involved in the advice process.”  I find this to be a disturbing fact, as it has not been demonstrated, through a strong body of academic research, that important financial and investment decisions are being properly made with the use of such “pure” technology solutions.

For example, FINRA's report provides evidence of the use of computer algorithms to determine the appropriate asset allocation for a client, without human input into this all-important asset allocation decision, is problematic. FINRA notes (p.3 of the Report) that “implementation of methods for specific investing tasks, for example asset allocation, may produce very different results.”

While FINRA’s report notes that assessing a client’s risk tolerance is important (see p.4), surprisingly nothing in the report addresses the client’s need to take on risk – arguably a more important factor in the asset allocation decision. There are clients who possess either lesser or greater need to take on risk, in order to achieve their lifetime financial goals. For example, a 25-year old with the goal of retirement may possess both a high risk tolerance and risk capacity, but if the account has $4,000,000 in it the need to take on risk may be minimal.

[FINRA defines “risk capacity” as "an investor’s ability to take risk or absorb loss.” Under this definition, I have clients who have the ability to take on far more risk, but not the need to take on more risk. Some advisors may view “risk need” as an element of a client’s “risk capacity” - although the terminology is not a good fit, in that regard.]

Likewise, a 55-year old client may possess, as measured by various risk questionnaires, a low risk tolerance. The 55-year old client may also possess a more limited risk capacity, due to a shorter time horizon and other factors. However, if the 55-year old client is “substantially behind” in saving for retirement, then the 55-year old may possess the need to take on more risk, beyond that reflected in either a risk tolerance or risk capacity analysis. A substantial discussion may be required of the client, relating to possible outcomes in such a scenario. In fact, if less risk tolerance is to dictate the investment portfolio's strategic asset allocation, the client’s goals may need to be adjusted.

The absence of FINRA’s explanation of whether a client needs to take on risk, and other terminology in its report, flows back to the broker's adherence to the suitability standard using vague terms to describe clients, such as "aggressive" and/or "capital preservation." This methodology is too simplistic in the fiduciary environment, and should be abandoned.

FINRA’s Omits (AGAIN) Any Discussion of the More Stringent Fiduciary Obligations Which Brokers Possess When in Relationships of Trust and Confidence with Their Clients.

On page 7, FINRA notes that “broker-dealers should disclose if the digital advice tool favors certain securities and, if so, explain the reason for the selectivity and state, if applicable, that other investments not considered may have characteristics, such as cost structure, similar or superior to those being analyzed.” Yet, FINRA continues to omit any discussion in its rules, and in its many reports, that brokers and their registered representatives often serve as fiduciaries to their client, whether due to the application of state common law, the federal or state Investment Advisers Acts, or ERISA.

As a result of FINRA’s failure to address fiduciary obligations, registered representatives may incorrectly believe that disclosure is all that is required when a conflict of interest is present. Under a fiduciary standard much more is required: disclosure of all material facts, the duty on the registered representative/fiduciary to ensure client understanding of those facts, the informed consent of the client (and no client would submit to being harmed), and even then that any proposed transaction remain substantively fair to the client.

In over 75 years of its existence, FINRA continues to fail in its responsibility to educate its members that broker-dealer firms, and their registered representatives, are often fiduciaries, and that the duties they possess to clients extend far beyond that of the low standard of suitability. FINRA stated this fact early on, in one of its very first written reports to its members. But, it has utterly failed since then to embrace the fiduciary standard of conduct for its members when the firm/registered representative is involved in advisory activities, in which a relationship of trust and confidence exists with clients. (Isn't this often, if not nearly always, the case, for most registered representatives serving retail customers/clients?)

Indeed, the report notes that a great deal of “advice” is provided by both “pure” and “hybrid” digital advice platforms. Yet the report fails to discuss the fact that, given the nature and/or extent of the advice provided and the use of many digital advice tools on an ongoing basis to provide recommendations to client and/or to manage their portfolios (as well as other facts and circumstances present), many “pure" digital advice platforms will likely held to a fiduciary standard of conduct – and, hence, additional obligations will be imposed.

I've said it once, and I'll say it again. FINRA should be disbanded. It has a history of protecting its BD firm members, rather than serving the public's interest. It is the worst regulator on the planet.