Aggressive strategies are not always detrimental when constructing an investment portfolio. The problem is most investors are unsure of what it means to have an aggressive investment strategy. How does this investment style impact returns and when should an aggressive investment strategy be adopted? Moreover, if you are an aggressive (or conservative) advisor, how can this impact the advice you give?
“If proper planning has occurred, the advisor should never have to be aggressive with the client’s serious money,” says Peter Merrick, CFP and president of MerrickWealth.com, a fee-for-service financial planning and executive benefit consulting firm in Toronto. “Where advisors might be aggressive is with a small portion of a client’s overall portfolio, like [putting] 5% in gold, for example.” However, Merrick emphasizes that a “trusted advisor should be the voice of reason for the client. Remind the client of the plan and keep them focused on their goals.”
Marc Lamontagne agrees with Merrick, but he also believes that if an advisor has an investment philosophy that is not aligned with the client’s investment goals, this should not have a bearing on the portfolio, at least in theory. An Ottawa-based CFP with more than 15 years’ experience, Lamontagne explains that every advisor is required to assess a client based on several different factors to help advisors ascertain the best investment strategy for the client based on their risk tolerance and risk aversion — a strategy that is separate from the advisor’s personal investment philosophy.
“It’s not unusual to see an advisor’s portfolio much more aggressive than a client’s portfolio,” says Lamontagne. “Part of the reason is we are more knowledgeable and have a good understanding of what the risk is and willing to tolerate much more losses than a client would.”
Some aggressive advisors, though, “tend to advertise their expertise by advertising their rate of return, as opposed to advertising a service or advertising financial or comprehensive advice,” says Lamontagne, citing advertisements from daily newspapers that boast a rate of return around 20%, as examples. “When you put that upfront, you are an aggressive investment advisor.”
However, some advisors who have aggressive investment strategies are not aware that their investment strategy is aggressive, says Douglas Nelson, a Winnipeg-based CFP. “Some do not truly understand just how aggressive [an investment vehicle] really is until they go through a market downturn.”
He also points out that some strategies, using options for example, are not inherently risky, but can be in certain contexts.
For that reason, Don McFarlane, CFP and an independent Assante advisor in Thornhill, Ontario, believes advisors need to be better educated about investment vehicles and the ramifications they can have on the client’s portfolio.
McFarlane recalls years ago, when he was first building his book, he received a call from a branch manager who suggested McFarlane put his clients in a particular segregated fund. He asked why and the manager’s initial response was that McFarlane would get a higher commission. When pressed further, the manager explained the fund had a longer deferred sales schedule that committed clients for an additional three years, and enabled the company to build in higher commissions.
“That’s not how I do business,” he says. “I could be a star in a hot market and push my clients into the flavour of the month, but I know, sooner or later, chickens come home to roost.”
According to Nelson, the best-run advisor operations are those that clearly describe their investing style upfront. McFarlane is perhaps a good example: “I manage my own funds and most of the funds I recommend I hold in some form or another.”
Merrick says there are five different ways an investor will look at maximizing their returns: Wealth preservation, tax minimization, creditor protection (if applicable), wealth accumulation and wealth distribution. “When you rate a client on their desire and they rate high on number four — wealth accumulation — you know their investment goals are more aggressive.” A client, then, is either aggressive or not, he says. An advisor may be able to adjust what a client is doing with their portfolio by educating them — teaching a client that GICs may not be the only method for investing money and securing the principal, for example — but they cannot teach a client to be aggressive.
Lamontagne believes the conflict between style and strategy really comes up when a client wants a more aggressive strategy than is comfortable for the advisor. “The problem with letting a client be in a more aggressive portfolio than an advisor is comfortable with is that ultimately the advisor is responsible for that portfolio,” he says. “When the client blows themselves up, the advisor will, eventually, be blamed.” Investors looking for consistent 12% to 15% rates of return “have unrealistic expectations,” he adds.
As a result, he believes an advisor needs to be self-aware and turn an unsuitable client away when necessary. “It takes a mature advisor to say no.” Most of the time, though, clients simply need to be educated on what expectations are realistic.
In order to educate the client, an advisor must first be educated. Merrick suggests advisors assess themselves, not just their clients, for risk tolerance. “You have to know yourself. You have to take the tests yourself.”
Merrick points out, though, that these tests are only the start of self-assessment and client-assessment. “The results are contextual. For example, if a client is thinking about a house purchase six months from now, then that client may be very conservative in the short term and very aggressive in the long term. But these [preliminary] questionnaires are not contextual.”
It’s this lack of context — and the inability to determine accurate risk tolerance — that prompted Nelson to start developing supplementary educational material for advisors. The Knowledge Bureau author says there are two distinct components of risk that need to be taken into consideration when measuring risk tolerance: financial risk capacity (the ability to financially absorb risk) and emotional risk capacity (the ability to stomach volatility).
“These two must be separated and measured independently to gain consistent and accurate test results,” says Nelson. When clients and advisors are asked to rate their level of risk through typical questionnaires, he says an inaccurate portrayal of risk emerges. “When they are combined in the same questionnaire, results about one’s true ability to emotionally stomach risk become skewed.”
Like Merrick, Nelson says studies show that investment time horizons and the need for liquidity, both common questions found on all KYC documents and most asset allocation questionnaires, have more to do with financial risk capacity than emotional risk and should not be a part of the risk-profile questionnaire. They say the same studies show that asking only 10 questions can also skew the results.
“For a test to be valid, the same question needs to be asked two or three times, from different perspectives, so as to determine accuracy and consistency.”
At present, it appears that no specific risk-assessment tool is taught at any college or university, but a few schools have adopted personality tests as a method of self-examination.
Although he says general rules of thumb are not set in stone, McFarlane says he follows a guideline, developed through years of self-analysis, client-awareness, and dealer education: “For clients who are more aggressive you examine the efficiency curve. You want to be at the outside end with younger clients and closer to the centre with your older clients, depending on their risk tolerance.”
Originally published in Advisor’s Edge Report in January 2008