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Risk Tolerance Dysfunctions

For more years than I’d care to name, I’ve been trying to put my finger on exactly why I have a such a huge problem with the traditional (Think: Riskalyze, now Nitrogen) risk tolerance assessments in the financial planning profession.  I actually had a negative visceral reaction to the original Risklyze tool even before it hit the market, when I was invited to test it out myself outside the T3 exhibit hall.

Yes, I was bothered by the fact that it took such a complicated psychological issue and rendered it into an overly-simplistic two-digit number—your ‘score,’ so to speak.  I was bothered by the fact that just about everybody who takes the test falls into the moderate range, which told me that the whole exercise was essentially meaningless.

The test mashed up risk tolerance, risk capacity and risk perception (people see only upside during a bull market, and only risk during the bearish times), which means the scores could be different for different time periods, and might lead to clients taking on more volatility in their portfolios than they could afford, or perhaps less.

And I feel like the implied assumption that volatility equals risk is at best simplistic, at worst highly-misleading and potentially dangerous.  The connection may be high in the short-term, but in the longer-term, volatility is your client’s best friend.

But, as I said, there was something else, more critical and important, that I had never been able to articulate until I read a recent white paper by the nebowealth organization (www.nebowealth.com) called “The Perils of Outsourcing Asset Allocation to a Risk Score.”

Nebo is basically a software program that optimizes client portfolio design for three factors—time horizon, the actual goal to be achieved, and risk tolerance.  The goal to be achieved is really many goals: children’s college fund, buying a beach house, retirement, a legacy, etc., but the point here is that nebo addresses risk capacity and redefines risk far more precisely as not having the financial wherewithal to fund a client’s various goals when the money is needed.  That, of course, means you need to include the time horizon, actually different time horizons, which means that volatility can be foe or friend depending on the time distance between here and there.

Nebo also defines risk tolerance somewhat differently from the simplistic 1-100 score; it asks clients how much they could tolerate losing if we were to encounter another bear market (think: 2008), and optimizes for a portfolio that would lose that much and no more under bearish conditions.  (You can actually test various bear markets and adjust accordingly.)

The software, in other words, answers all of my objections to the whole risk tolerance issue—similar to how StratiFi (https://www.stratifi.com/) and Andes Wealth Technologies (https://andeswealth.com/) have expanded risk assessment into multiple dimensions.

But in the preamble to the white paper, nebo’s authors directly address the thing I had been missing.  The white paper points out that, today, many (most?) advisors create client portfolios based on that 1-100 number—and even market that way, telling clients, before any financial plan has been formulated, that they will normalize their retirement portfolio with their risk score.

In other words, the traditional (Riskalyze/Nitrogen) risk tolerance instruments  have, over time, effectively detached portfolio design decisions from the financial planning analytics, and reattached them to a process that I find simplistic and viscerally misleading in a number of ways.  This trend away from a direct linkage between portfolio design and the financial plan was happening so slowly that somehow I missed it until (as the nebowealth white paper notes) it had become essentially mainstream in the planning profession.  

The whitepaper is prominently displayed on the nebo website, so you, too, can enjoy this epiphany and see some of the ways that we can restore the connection between planning and portfolio design—and also do a better job of bringing time horizon and goals back into the risk tolerance picture.  What I mostly want to do here is apologize, not for the fact that I’ve criticized the naive risk tolerance instruments that many advisors use, but for not realizing the most important thing to criticize them about.