The Superiority of a Goals-based Approach to Risk Management and Financial Advice

The Superiority of a Goals-based Approach to Risk Management and Financial Advice

Professional financial advisors understand the importance of aligning clients’ risk tolerance with their long-term objectives. Unfortunately, the trade-off is too often an unacceptable compromise — reduce the objectives to stay within a client’s risk tolerance range or have the client take on a level of risk that is beyond their comfort level to achieve the returns required to meet their objectives.

While the application of technology has added discipline to the process of determining the “best fit” between objectives and risk, the results so far, are far from perfect. For example, most advisors use some sort of “risk tolerance questionnaire” to assess client risk preferences. However, research has shown that the majority of RTQs are either based entirely on self-assessment by the client or algorithms that have little or no ability to predict a client’s behavior under the stress of varying market conditions.

So, how can we achieve a better outcome? Our view is that a strategy that places a client’s goals at its center maximizes the chance of getting both the investment plan right and making sure the investor’s emotions are compatible over the long haul.

But isn’t that the same thing as what we do now – balancing risk and potential reward?  To some extent, the answer is “yes”; however, there is a difference between how people feel and what they need to do to be successful. Understanding a client’s risk preferences and hence their behavior is important in helping them stick to a well-designed plan, but it should not be used as the primary determinant to design their investment portfolio.

What does a “goals-based” approach look like and why is it superior? First let’s note that it is interactive between client and advisor, resulting in deeper client engagement and collaboration. Second, it is an iterative process where the portfolio evolves over time based on changing preferences, needs and experience. This increases client retention, improves the likelihood of long-term progress towards goals and enhances overall satisfaction with the client/advisor relationship.

Identify goals and develop a “sufficient investment strategy” that has a high probability of reaching those goals

Objectives include goal amount, time until drawdown, current amount of investable wealth, and ongoing contribution/savings rate. Given this information, advisors can estimate what portfolio performance would achieve the stated goal with some high degree of confidence.

If this process were built into responsive software, people with unrealistic expectations of market returns would be identified right away. In addition, this highlights the “dials” people can use with the biggest effects on their financial outcomes.

Show what a sufficient investment strategy will look like

The purpose of this is to show that volatility is both a normal and expected part of investing over the long-haul. We do this by illustrating realistic expectations in terms of gains, losses and recovery periods applying a client’s sufficient investment strategy over their time horizon. This provides a meaningful context that is personalized to an investment strategy that has already been determined to fit the investor and serve their long-term goals.

During this step, we assess the investor’s reaction to anticipated portfolio performance. If they indicate they are “uncomfortable”, we demonstrate how they can reduce anticipated volatility and still reach their goals by “dialing up” the amount of time before drawdown, the amount of investable wealth, the savings/contribution rate, or scaling back their goal.

Help clients have real-life expectations about what their gains and losses are going to feel like

“Risk reactivity” is the stability of a client’s risk preferences as they experience changes in their wealth and receive new and updated information.

Illustrate month-to-month changes in a client’s portfolio going back over a simulated period using their investment strategy and its expected performance based on real market data. Changes in wealth are shown in real dollars (vs. percentages) that correspond to the gains or losses that would have been experienced. In our view, too much attention has been devoted to risk aversion in the planning process, whereas risk reactivity is far more important in understanding the impact of bad decisions people make in times of market upheaval.

Help clients stay on course

Financial or investment planning software programs often show the daily (or other short-term) performance of a portfolio’s holdings, which is unimportant to long-term performance and can generate ineffective emotional reaction.

Better feedback is provided by calculating a single number, being the “probability of reaching the long-term goal”, given the client’s investment strategy, ongoing contributions, and current market conditions. In this way, goals continue to serve as the foundation and focus for planning over the duration of the client’s time horizon.

The purpose of the Goals-Based Risk approach is to improve the quality of financial planning, bolster investor’s risk resilience, and, in doing so, better help investors succeed and reach their financial goals. The framework addresses different problems sequentially to build a solution. It enables meaningful dialogue with real people as they try to balance what they want with personal constraints and market realities.

You can read the full research paper from Morningstar’s Behavioral Research team here.


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I have been using FinaMetrica for over 17 years for onboarding new clients. They like the extensive value of the reports; but what we appreciate is the innovations in technology, the value of the client-facing materials and the development of the life-long client relationships as I get to really know their behavioral tendencies. FinaMetrica has assisted me in building a very successful practice and we highly recommend it for any advisor who wants to enhance the overall value of their client relationships.

Ron Wilkinson - Portland, Oregon, USA
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