Advisors ignore clients’ true risk capacity

Relying solely on risk-tolerance questionnaires to assess clients is wrong, Tom Idzorek of Morningstar told the New York Consultants Conference, hosted by the Investment Management Consultants Association (IMCA) earlier this week.

Read: Blog coverage of this session

In fact, the behavioural finance professors who helped Ibbitson craft today’s familiar questionnaires were skeptical of their true value, he said, since the categories used are too simplistic.

Further, they only measure how people would feel if they lost money, or risk preference. When markets are doing poorly, risk preferences go out the window, and most people invest conservatively, he said. The questionnaires’ don’t assess a person’s risk capacity—how well their personal attributes will weather an economic storm.

“We need to take a holistic approach to measure both,” Idzorek said.

To do so, advisors must recognize that clients’ economic wealth is composed of both financial and human capital.

“Human capital involves a person’s savings capacity, earning potential, skills, intelligence and charisma,” he said. Young people have mostly human capital and little financial capital. Over time, they parlay their skills and education into higher and higher earnings.

On the other hand, people near retirement have mostly financial capital; they’re not going to be working much longer, so their chances of converting human capital to financial capital are minimal.

A person’s human capital should affect asset allocation. Human capital is a wonderful inflation hedge, said Idzorek, because wages tend to rise with inflation. As long as a person increases her earning power, she’ll stave off most inflation effects. But someone near retirement can’t, and that’s when advisors should use financial tactics to hedge inflation.

He also encouraged advisors to think about a person’s chosen career. A tenured university professor has much more certain income—think of them like coupon payments—than an investment banker in New York City (think of 2008).

“Professors are more bond-like,” said Idzorek. “So they can take on more risk if they want to because of the safe aspect of their human capital.”

On the other hand, “The typical investment banker probably had to tap into his savings to pay for living expenses in 2008. So he should invest more conservatively than the tenured university professor.”

Idzorek likened the cash-flow characteristics of human capital to a junk bond.

“During good times, there’s nice, steady cash flow, but periodically there’s a interruption” where yield goes to zero, he said, such as unemployment, career breaks, and going back to school. Regardless, “The typical person’s human capital is like 70% bonds, 30% equities.”

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.