WHY CLIENT RISK QUESTIONNAIRES ARE POOR INDICATORS OF WHAT A CLIENT SHOULD DO

Long time readers know that I have always indicated that the questionnaires put out by literally all the fund families, financial planning software companies, analysts, etc. do a poor job of determining what an investor SHOULD or NEEDS do. They invariably focus on what an investor WANTS to do. In order to provide more detail, I took a questionnaire from one of the most recognized analysts in the business- Ibbotson Associates (it was used for John Hancock 1998) and provided commentary for each question asked. But the cynicism is essentially the same for Fidelity, Vanguard, Quicken or any form.

1. INVESTMENT GOALS: "Your goal is $_______. Your total savings for this goal is $_________.

• You intend to begin withdrawing assets from your account for this goal in a. less than 3 years, b. 3 to 6 years, c. 7 to 10 years, d. 11 to 15 years, e. over 15 years
• The period of time over which you expect to withdraw assets for this goal is a. 1 to 5 years or lump sum, b., 6 to 10 years, c. 11 to 15 years, d. over 15 years.

  
  

Commentary- this is O.K. since it is basically gathering information. However, I would ask how much is currently being invested on a monthly basis. It's at least as important as the current amount saved.

2. International investments are often added to a portfolio for additional diversification. Would you want international investments to be part of your portfolio? Yes No

Commentary- it is a true statement that international investments provide diversification, but my concern is that the investor- at least the type that has to fill out this type of questionnaire- simply has little idea as to why. Overhearing someone talk at a cocktail party about how well someone has done in Hong Kong stock provides no insight for the use of an international fund. Sure, some can say that this is an introductory overview for a client, BUT THIS WILL BE USED TO DETERMINE A PROJECTED FINAL ALLOCATION. Based on the answers, the forms generate the "ideal" type of allocation that the client should utilize and the fund companies (normally) will have everything there for the client to purchase. But there is insufficient knowledge about any of the allocations on which to make a final determination.

3. Please indicate the approximate degree that you have used these investments in the past and whether you would invest in them in the future.

• Money Market Funds
• Bonds/Bond Mutual Funds
• Stocks/Stock Mutual Funds
• International Funds

Commentary- again the ridiculousness of the questionnaire assumes that the client properly used any of the funds previously or knew what they were doing when they did. My point is that if the client has NOT used stock funds before it probably is due to the fact that they had no idea of what they were doing in the first place and may not want to use them at any time in the future. That's bad planning. Anyone that indicates that they have NOT  used stock should be flagged immediately as to what they SHOULD be doing/MUST consider. Otherwise, the computer program may exclude stocks or give only superficial comments about the need for stocks.

4. Inflation can reduce your purchasing power by eroding the return on an investment. How do you feel about the impact of inflation on your investments?

• I am willing to accept minimal risk that may result in minimal short term losses and prefer investments designed to keep pace with inflation over the long term.
• I am willing to accept moderate risk that may result in moderate short term losses in order to achieve long term results that may moderately outpace inflation
• I am willing to accept higher risk that may result in higher short term losses in order to achieve long term returns that may significantly outpace inflation

  
  
  

Commentary- The form provides nothing to indicate just what inflation will do to an investment over time. They must provide what has inflation been and what is projected. And what have been the historical returns on money market funds, bonds, U.S. stocks and international funds. How is someone going to choose if they have no idea what the numbers are??? THEY CAN'T!!!!

5. Over the past three months, your $10,000 investment has declined to a value of $9,000, resulting in a $1,000 loss. How would you react?

• I would be very concerned and would sell my investment and invest my money elsewhere
• I would be somewhat concerned and would consider changing my investment
• Although I would be concerned about the loss, I would maintain my investment.

Commentary- Why did it lose? Was it a bum investment? Was it due to a "standard" market correction? Was it due to poor allocation? The question needs to address why the decline happened since that would primarily determine what the investor SHOULD OR NEEDS to do. Since effectively none of the questionnaires address that, the question- at least for my position- is sophomoric and useless.

6. The (graph) shows the possible returns of four different $10,000 over a one year period.

Portfolio A- Best gain= $750. Worst gain= $250

Portfolio B- Best gain = $1,500. Worst loss = $250

Portfolio c- Best gain + $2,250. Worst loss= $750

Portfolio D- Best gain = $3,000. Worst loss $1,250

Which would choose to invest in?

Commentary- actually I don't have much problem with this in its graphical context. It actually reflects a form of standard deviation. But the question focuses on the use of ONE investment, not how they might be combined together to provide the correct allocation. With that missing, I don't think it does a good job.

7. When purchasing automobile insurance, I look for a policy with

• Low deductible even thought the policy costs more
• A moderate deductible to reduce the cost of the policy
• A high deductible in order to attain the lowest policy cost.

Commentary- This might be O.K as a reflection of basic risk.

8. Which of the following statements do you feel best describes you as an investor

• I prefer investments that are designed to provide stable returns with a minimal chance for loss on my investments
• I prefer investments that are designed to provide moderate returns even if I have to assume a greater chance for a loss
• I prefer investments that are designed to maximize returns and realize that such investments also carry the highest chance for a loss

Commentary-Notice that all the questions ask the investor what he prefers to do- not what he/she SHOULD OR NEEDS TO DO. I categorically state that is a sham. A budget determines how much discretionary income is available and/or how much money may be available for the future. With those numbers, one then determines if the most conservative investments will work or if more aggressive investments are mandatory. I have done this with many clients who may be the most conservative type of investors since they may never have been in the market. But when you look at people living till 80 or 90, they don't have a choice as to what they HAVE to do (stocks) irrespective of what they would like to do (money market funds). Without identifying this issue, any questionnaire is a waste.

9. You held a portfolio of stock, bond and money market investments (but a money market fund is NOT an investment) that has increased in value by 7% this year. The general stock market has increased by 15% over the same period. What would you do?

• I would maintain my current portfolio
• I would increase my stock position by a small amount
• I would sell the other investments and make stocks a majority of my portfolio

Commentary- first of all, a 15% return is an anomaly- the return over the past 50 years is 10%+. And why did the market go up- was it due to lower interest rates, great dividends, was there an election, what??? Further, if you look at the return of 7% overall it may mean that essentially very little was invested in stocks. For example a 20% position in stocks x 15% return = 3%. If bonds represented 50% and a return of 7%, that would provide a 3.5% return. Together that's 6.5%. That means that the other 30% was in money market funds earning 1.7% overall (30% x 1.7%= 0.5%). Well, that doesn't work.

If I use 30% stock for a 4.5% partial total and the rest in money market funds, it would have earned 3.6% (70% x 3.6% = 2.5%)- which is far more realistic. But since the allocations are not identified and/or don't make sense, the suggestions that a potential investor might do X, Y or Z is without merit.

Those were all the questions. Now the investor hits the SUBMIT button and the allocation indicates "your results will compare your current asset allocation with a suggested asset allocation that can help you reach your goal without compromising your tolerance for risk."

Rubbish.

PROSPECTIVE INVESTORS ARE BEING LED TO INVEST HARD EARNED MONEY WITHOUT A BASIC UNDERSTANDING OF RISK AND REWARD. THE FORMS LOOK VALID AND ARE GREAT MARKETING TOOLS FOR THE SALE OF FUNDS. BUT I SUBMIT  THAT IS NOT GOOD PLANNING AND A FRAUD ON THE PUBLIC.