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ELITE ADVISOR BEST PRACTICES

How Much Risk Are Your Clients Buying?

Chances are they’re not being adequately compensated. Elite advisors can step in to help.

By Guy Baker

Key Takeaways:

  • Every investor buys risk, but they rarely know how much.
  • Virtually no one has a written investment policy statement.
  • Showing the relationship of risk to expected return can yield much fruit.
  • Understanding why we are in this business will guide our future direction.
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I recently had lunch with two CPA friends who have served their clients faithfully for more than 45 years each. In fact, our combined age at the table totaled 200 years. Shocking! As we reminisced and played the name game—people we knew and clients we had served—I felt like I was in a time machine. At the same time, I saw the future…and it was me.

Eventually we started to discuss the present and my friends told me they had been working with clients in money management. One of the CPAs said he had several brokerage firms as clients and he would not trust any of them with his money or with his clients’ money. The other CPA said he found that when he asked his clients, they told him they were content with their current brokers and he had been unsuccessful in getting them to change.

As asset managers and wealth planners, all of us face that deciding point in an interview when our prospective client tells us they have been with their broker for 15 years or more and they wouldn’t think of changing. However, after probing a bit, we often soon discover that a prospective client is really not all that satisfied and their portfolio has actually not done all that well. What do we say next? Where do we take the interview?

Power of the Second Opinion

I love Nick Murray’s suggested question: “Do you have enough confidence in your broker to have a second set of eyes review your portfolio to see if you are really getting the best advice?” A second opinion is a powerful concept and can yield significant fruit.

What I ask, to great success, are two simple questions: “Do you have a written investment policy statement?” and “Do you know how much risk you are buying?”

It never fails to bring a quizzical expression to prospective clients’ faces, usually followed with questions such as: “What do you mean? How much risk am I buying? I didn’t even know I paid for my risk!” And I say, “Of course you are buying risk; every portfolio has inherent risk hardwired into its DNA. The question is not whether you are buying risk, but whether or not the risk you are buying is consistent with your expected return. Why don’t you let me do an analysis of your portfolio and let me measure your risk/return index?”

I also ask to see a copy of the prospective client’s written investment policy statement. Guess what? They won’t have one. But as we all know, the prospective client’s money is being invested according to some policy, right? Otherwise, how did the client even get their portfolio put together? A portfolio is invested either by design or by default. So does an investor have an IPS?

Once I obtain a copy of the prospective client’s portfolio, we analyze their allocation for two things. Foremost, we compare their asset allocation to their risk tolerance index and determine what their investment policy actually is. This gives us two key pieces of information. First, it tells us whether their portfolio is consistent with their risk index. Second, we can see how their portfolio is constructed.

Next, we measure the expected return for the prospective client’s portfolio. We do this by using proxies for their allocation. Now we know how their allocation would have performed over the historical time frame we are assessing. It also tells us how much risk they are buying. In almost every case, their risk index is 20 to 25 percent higher than the appropriate risk tolerance for their allocation and expected return. And in most of our analyses, we find the risk is far greater than the client’s stated risk index would warrant. This can often be attributed to a change in the prospective client’s current attitude toward their historical performance. But every one of us knows how to handle these inconsistencies.

When I bring back the analysis, it is easy to show the prospective client the anomalies in their portfolio. Yes, they are buying too much risk. Their allocation is inconsistent with their investment policy statement and finally, with some subtle changes, their expected return could be enhanced and the risk reduced. When shown the differences, I frequently hear, “Why wouldn’t I do this?” And of course, that is music to my ears.

Each of us needs to ask ourselves this question: “Why are we in this business?” Is it to make money for our families and employees, or is it because we want to bring better results to our clients? It may be both. But until we really understand the why of our selling proposition, it is unlikely we will ever achieve the results we are seeking, professionally. Managing risk is the doorway to our financial and professional success. The more capable we are in showing our risk management methodology, the more likely we are to achieve both our clients’ long-term goals and our own long-term goals.

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About the Author

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com.