This is the first in our Foundations series of blog posts. The goal of the series is to cover some of the key classical and behavioral economic building blocks, and how they play out in understanding clients more deeply in an advice context.

This post is a two parter—the first part covers the problems with prevailing “stated preferences” client profiling approaches. The second part will introduce “revealed preferences”, the method at the heart of the next generation of client profiling solutions.

In this post:

  • RTQ’s and investor interviews are insufficient for understanding a client’s investment profile
  • The fundamental limitations of Stated Preference client profiling methods

Part I: RTQ’s and investor interviews are insufficient for understanding a client’s investment profile

The two pillars of financial advice are the ability to understand clients in all of their complexity and the ability to construct a suitable portfolio and plan to meet their needs. Each pillar is essential, but only one, portfolio management, has benefitted from modern mathematics and computing techniques.

Today, portfolios are constructed with scientific precision to manage risk and deliver personalized outcomes based on the client’s investment preferences. In contrast, firms still employ qualitative and inaccurate methods for profiling clients, despite increasingly complex client preferences and priorities. If the client profile underlying a portfolio does not accurately reflect the client’s actual preferences, goals, and constraints, then clients will ultimately end up with portfolios that are unsuitable for them. This is a monumental problem.

 

The fundamental limitations of Stated Preference client profiling methods

Profiling methods vary, but their thrust is to understand and measure a client’s:

  • Preferences (risk tolerance) – real world, financial choices a client would make if they truly understood the available options and had time to thoroughly consider them.
  • Goals (risk requirements) – a client’s primary intentions for their financial assets
  • Constraints (risk/loss capacity) – a client’s capacity to pursue various goals, driven by age, income, assets, tax policy, and other considerations

Historically, advisors have used investor interviews and/or risk tolerance questionnaires like the one shown below to assess client goals and to profile their preferences and constraints:

Source: https://www.pocketrisk.com/wp-content/uploads/2018/11/morningstar.pdf

The results these methods produce are imprecise, incomplete, and infrequent. Investor interviews and risk tolerance questionnaires rely on ambiguous language with no underlying mathematical theory supporting their scoring methods or definition of risk, making them: