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A study conducted in the early 2000s asked MBA students at Johns Hopkins to fill out risk tolerance forms for six different financial firms. The point was to determine how consistently the questionnaires, which the study noted “differ widely” in terms of what was asked, assessed the same person. The answer: not consistently. “It is not appropriate to attempt to assess the personal nature of risk aversion with some arbitrarily designed questions,” the authors concluded.

Fifteen years and a crushing financial crisis later, the know-your-client (KYC) process is still dominated by “arbitrarily designed questions.” There are signs of change, however, spurred in part by robo-advisors and user-friendly tech tools in other domains.

Advisors are coming around to the idea that risk assessments aren’t something to rush through. Rather, the KYC process is being recognized as a crucial early step in establishing the kind of close advisory relationship that can withstand both competition from robo-advisors and market turmoil. Advisors still filling out paper forms for separate accounts and perfunctorily checking off answers risk being left behind.

Catherine Wood, chief marketing and innovation officer and senior vice-president of online and digital wealth at Aviso Wealth in Toronto, says it comes down to meeting client demands at a time when large players like Google and Amazon are defining expectations.

“If we’re paying attention to how consumers consume and we’re looking at other technology players in the space, [firms] are probably quite concerned that if they don’t start to embrace technology or provide relevant experiences, clients will find it elsewhere,” she says.

It’s up to financial services firms to provide services that are simple, relevant and easily consumable, she says.

Room for improvement

There’s plenty of evidence that KYC processes have a ways to go. The Ontario Securities Commission (OSC) took up the issue of risk profiling in a 2015 report and at an industry roundtable the following year. The regulator found most of the questionnaires in use (83%) were not “fit for purpose”: not thorough enough, containing confusing questions, and using poor scoring models. Three-quarters of questionnaires merged multiple factors ambiguously, and more than half had no mechanism for recognizing “risk-averse clients who should remain only in cash.”

A 2017 working paper from the University of Georgia’s Financial Planning Performance Lab found that advisors relied primarily on a client’s age when assessing risk. The researchers presented more than 200 advisors with nearly identical client scenarios; age and employment status were the only differences. Despite the similarities, the portfolios that advisors recommended for the clients were very different.

Advisors regularly determined a client’s equity allocation by subtracting their age from 100, the paper said.

Amy Hubble, principal investment advisor at Radix Financial in Oklahoma City and one of the paper’s co-authors, found the inconsistency surprising.

“If one person were to visit 100 doctors, for example, and get a completely different diagnosis at each doctor, that’s a problem,” she says.

KYC problems show up in practice, too. An April 2019 Mutual Fund Dealers Association of Canada (MFDA) report found reps who had uniform KYC information for all their clients despite differences in age and financial situation. In some cases, according to the report, reps said the KYC information matched their *investment philosophy rather than the client’s actual risk tolerance, investment objectives and time horizons.

Assessing risk brings out the biases of both the client and the advisor. Applying what behavioural scientists have learned about those biases, as well as new tools that incorporate those insights, could lead to more accurate client profiles—and richer client-advisor relationships.

Lessons from behavioural science

David Lewis, chief client officer at behavioural science consulting firm BEworks in Toronto, points to a number of problems with risk assessment processes (see “Common flaws” below). A lot of KYC tools measure attitudes toward risk but miss risk perception, he says. Research shows people don’t differ much on risk attitude, as measured by “How would you feel if the market dipped X amount” questions.

If clients are asked how likely it is that the market will go up or down 500 points, however, “they vary significantly on their perception of how risky the market is,” he says.

If questionnaires are only measuring attitudes to risk, firms can end up with clients who appear risk-averse because they perceive the market as riskier than it really is.

“That’s why you find people often over-allocate to short-term and low-risk investments,” Lewis says, “whereas we know that in order for people to have enough money to retire, they actually need to take more risk.”

Jean-François Démoré, president and certified financial planner with Innova Wealth Management of Aligned Capital Partners in Sudbury, Ont., says high-tech compliance tools are also affecting how firms evaluate clients’ risk profiles. As a member of Advocis’s technology task force, he’s reviewed software in the U.S. and U.K. that uses artificial intelligence (AI) to monitor trade activity.

“The tools are based on pretty simple math, which is basically the [investor] has to answer the mandatory multiple choice questionnaire that codifies the risk tolerance, and then they assign a score for each client or plan,” Démoré says. Each trade is then compared to that score to determine if it’s suitable, and advisors have to justify trades that are flagged.

The reductive nature can be frustrating, Démoré says, especially when outdated rules such as a client’s age are used to determine risk tolerance.

“It’s infuriating to advisors who take the time to actually get to know their clients,” he says.

Thorough versus simple

The OSC roundtable document observed the challenges with balancing thoroughness and simplicity, noting that a time-consuming risk-profiling process could lead to “cursory or incomplete answers to important questions.”

It also warned that using long, detailed questionnaires puts advisors at greater risk of “merely using it as a script.”

Randy Cass, CEO at Nest Wealth, says that digitizing the KYC process has helped firms see problems with their questionnaires. Nest Wealth launched as a robo- advisor but the majority of its revenue now comes from the B2B space, including from partner firms such as National Bank and Aligned.

Nest’s B2B platform allows firms to build KYC tools onto it, Cass says. Many of those firms’ risk surveys started with 50 or even 100 questions.

“One of the very first things that people recognized was that that doesn’t work as a piece of digital workflow,” he says. “The more questions you ask, the greater chance that people will just stop the process.”

Digitizing questionnaires that had hardly changed for decades led some firms to create more user-friendly versions, he says. Sometimes firms would discover that several questions had no impact on assigning an asset mix.

As firms make part of the onboarding process self-directed, Cass says there’s a tendency to want to make up for the loss of face-to-face time by adding more questions. But he says that’s the wrong approach. A digital questionnaire that has more than 10 or 15 questions begins to lose its “elegance,” he says, as well as the “transparency” as to which answers affect the outcome.

Besides, Cass says, “The purpose of this is not to get to the final outcome with your investors. The purpose is to get to the starting point.”

Nonetheless, some firms have moved to longer questionnaires. TD Wealth launched its Discovery platform in 2017, which has clients rate the accuracy of 50 short statements—covering topics as varied as vocabulary, attitude to chores, and comfort with strangers—to get a sense of their decision-making.

Discovery produces a “wealth personality” that describes a client’s level of spontaneity, self-discipline and amenability. It also identifies investing blind spots, such as being paralyzed by too many choices or focusing on short-term benefits.

Lewis says there are arguments in favour of both simplicity and thoroughness. Respondents can experience survey fatigue when there are too many questions, reducing the accuracy. But understanding certain facets of risk may require multiple questions.

Risk appetite and perception aren’t as straightforward to assess and require behavioural rather than attitudinal questions, he says. A client can say she’s a risk-taker, but when asked what she does when she goes to Las Vegas, the same client may say she plays the quarter slots. Questionnaires need to come at the topic in different ways to get the full picture, he says.

As more detailed methods are introduced, advisors may end up complementing their mandated KYC questionnaires with other tools.

“It’s hard for me to wrap my head around the fact that many institutions rely on five multiple choice questions to determine risk tolerance, when it takes me at least an hour of follow-up questions to ensure that I am building a portfolio that is truly suitable for each individual client, in good markets and in bad,” Démoré says.

Riskalyze, an Auburn, Calif.-based fintech, offers a tool available in the U.S. (the company is hoping to deliver its product in Canada by next year) that individual advisors can sign up for with a monthly fee. The platform is built around the behavioural concept of loss aversion: people are far more concerned about avoiding losses than achieving returns.

This often leads to clients sabotaging their own investments, CEO Aaron Klein says. “Warren Buffett probably said it best: investments are literally the only thing that the average consumer refuses to buy when they’re at their cheapest and only wants to buy when they’re at their most expensive.”

Riskalyze eschews standard labels such as conservative, moderate and aggressive, instead assigning a risk number (between one and 99) to clients based on a questionnaire of between four and 12 questions.

The platform provides a 95% probability range for how a portfolio will perform over the next six months, allowing advisors and clients to adjust how much risk they want to take. A sliding bar shows the range of gains and losses in both percentages and dollars. By showing clients that six-month results fall within the range they agreed to, the idea is to eliminate shocks and keep clients invested.

Klein says Riskalyze leads to fewer “talk-me-off-the-ledge” calls from nervous clients during downturns, and fewer angry ones in bull runs. If clients agreed that a 10% drop is within the normal range, they’re less likely to require reassurance. Conversely, if clients agreed that their risk rating is a 53, they’re able to understand that their portfolio will never beat the S&P 500 (which is a 78) when the market is rising.

Hubble, who co-authored the 2017 paper about overreliance on age for KYC, is now working on a risk-profiling project for the CFA Institute Private Wealth group. Her team is developing an approach that doesn’t use a single score. “Any time you’re averaging something, you’re discounting something else,” she says.

The method relies on three elements: the client’s need-based goal, objective ability to take risks, and behavioural risk tolerance. Time horizon, liquidity need and capacity for losses help determine the ability to take risk. A client’s behavioural loss tolerance is determined through a combination of willingness to take risk, investment knowledge and experience, risk perception and risk composure (how clients have behaved in the past). Questionnaires covering the behavioural side should be between 10 and 15 questions, she says.

The approach looks at need, ability and tolerance independently, and develops a score for each. This helps advisors identify situations where clients’ goals exceed their ability to take risk, for example, so advisors can determine whether or not they need to educate clients on their options.

“The research has shown that most clients would actually rather miss out on their goals than take more risk than they would otherwise be comfortable with,” Hubble says. “So it’s a very delicate dance as far as how hard you moderate or nudge the client.”

The goal isn’t to arrive at a specific asset allocation or decision on securities. A profile of low-high-moderate, for example, could point to a range and basis for asset allocations, she says.

Stronger relationships through tech?

Lewis says firms are starting to recognize the shortcomings of traditional KYC approaches.

If advisors can understand people’s reaction to risk, “then they’ll do a better job of maintaining those clients or ensuring that their clients maintain their long-term strategic asset allocation,” he says.

The OSC roundtable said KYC technology could be a “game changer” by empowering clients and increasing their responsibility in their relationships with advisors. It could also democratize advice, offering a level of sophistication to the average investor that’s traditionally been reserved for high-net-worth clients.

Freeing up advisors’ time could also allow them to serve more clients with smaller accounts. Onboarding used to require an hour-long meeting devoted entirely to paperwork, Démoré says. Now form-signing can be done electronically, allowing clients to go through the fine print at their own pace; back-end systems that autofill information across multiple accounts also speed up the process.

The result is more time to go over goals and the nuances of risk profiles.

“The industry’s becoming so tech-focused, with robos and those types of things, that an advisor’s ability to build and nurture deep, personal relationships with their clients is going to be the determinant of success,” Démoré says.

New approaches to risk assessment are part of a broader shift in the advice model, says Kendra Thompson, managing director at Accenture Wealth Management. As clients become accustomed to “rich digital experiences” elsewhere in their lives, they find it hard to understand why the person managing their finances can’t offer the same, she says.

“It’s no longer OK to receive 12 separate statements with no way of connecting them,” Thompson says. “Clients expect to be able to log in and see their whole financial picture and everything that advisors are doing for them in one place.”

Many firms are moving in this direction, even if it can be a slog to modernize back-office systems so client data is accessible in one place. Thompson says firms with systems organized by products and account types need to develop a single platform. For some, this will mean massive in-house overhauls; for others, it will mean partnering with fintech platforms to adapt existing systems.

There could be a role for regulators, too, in mandating a more consistent and streamlined KYC process. Thompson says the regulatory framework is still oriented toward product and account silos. Despite this, firms are seeking new ways to assess risk.

“This is the thing that’s interesting about this moment,” she says. “For years, [the regulatory framework] would have been the barrier that would have stopped the innovation. But now the demand from clients is so strong that they’re doing it in spite of that fragmented way of looking at accounts and households.”

Common flaws in the KYC process

Questionnaires are often conducted in a way that creates “demand characteristics,” says David Lewis, chief client officer at BEworks: clients naturally begin to answer in the way they think will please the advisor.

Another flaw is that the surveys are done when clients are in a cold, rational state when what’s needed is an assessment of how they’ll respond in a hot, emotional state. “The important thing is how you’re going to react when the market goes down 500 points,” Lewis says. “It’s not how you react when you’re sitting in a comfortable office, talking to an advisor.”

A 2016 Ontario Securities Commission roundtable on risk profiling said a client’s mood on any given day could “unduly influence” responses to questions measuring their level of optimism.

Framing is another common problem with risk assessments. Most clients will adjust to the middle-of-the-road option when presented with various scenarios, or what’s known as the Goldilocks effect, Lewis says. It’s a trick coffee chains have taken advantage of when creating cup sizes, and that restaurants use when suggesting tip options.

“You’re really not measuring what their preferences are. What you’re doing is just measuring their likelihood of picking the middle response,” Lewis says. “You have to be very careful about what scenarios you give people because that will affect their answers.”

Imagining a future self without enough money in retirement creates less psychological distress than actually losing money right now, Lewis says. To think long term, some “mental accounting”—separating short-term chequing accounts from retirement savings—can help clients understand why a 20% portfolio loss today has little impact if they’re investing for the next 20 years.

Presenting potential outcomes in dollar amounts helps clients perform the “mental time travel” required for retirement planning, since most people aren’t good at understanding percentages, Lewis adds.

*Correction: A previous version of this article contained an error regarding an MFDA report. That version stated there were cases where reps said the KYC info was tailored to match the client’s investment philosophy, rather than their actual risk tolerance, investment objectives and time horizon. In fact, the KYC info was tailored to match the rep’s investment philosophy. Return to the corrected sentence.