We are in the middle of a major risk management revolution that is calling into question our traditional definitions and processes for measuring and managing risk. One key area of concern has been the risk management questionnaire that most advisors use to determine the amount of investment risk to include in their clients’ portfolios and that have been built into multi-manager asset allocation programs and investment methodologies like Modern Portfolio Theory.
There has been an increased amount of scrutiny regarding the accuracy of these questionnaires and their efficacy as a long-term investment tool.
In hindsight, it seems that risk questionnaires were originally created as part of a simplified, paint-by-the-numbers investment sales process. However, as risk questionnaires have been evolving over the past 5 years, so has their value as an investment tool.
To better understand the evolution and improvements of these risk management tools, we talked to Larry Shumbres, CEO of Totum Risk – a FinTech company that provides a unique risk tolerance tool for financial advisors that calculates how much risk an investor can take given their current life situation (risk capacity) instead of the traditional model that only looks at how much risk an investor wants to take (risk preference).
We asked Larry to take us through the evolution of the risk questionnaire tool and to address today’s more innovative approaches and potential future developments.
Hortz: What fundamentally has been wrong with the traditional industry risk questionnaires?
Shumbres: This is such an important question and the foundation of Totum’s inception. We looked at what was wrong with traditional risk questionnaires and set out to create a product that addressed all of these concerns.
The most obvious flaw with traditional risk questionnaires is that they solely focus on psychometric preferences. The problem with this model is that preferences change all the time. To accurately calculate an investor’s risk tolerance, emphasis needs to be given to how much risk they can take given their current life situation. And since the average household has one major life event each year, it’s important to give the questionnaire annually to make sure their portfolio aligns with their life changes. Unfortunately, most advisors only give traditional questionnaires once, further reducing the efficacy of their risk assessment.
Another major issue is the questionnaire itself which is often too lengthy and includes questions that are not relatable to the client or difficult to understand. Additionally, what some companies claim to be algorithms are actually just standard deviation or weak methodologies that would not hold up in arbitration.
Hortz:How did Totum define the problem differently when you started the process to better refine and build a more effective risk analysis solution for the industry?
Shumbres: At Totum, we knew our risk tolerance questionnaire had to relate to the investor and had to have deep academic models and methodologies to help advisors and investors better understand their true risk tolerance/aversion. In order to accomplish this, our product calculates 3 different risk scores. The first two are the investor’s risk capacity score and their risk preference score. When presented on an easy-to-read line graph, the space between these two numbers illustrates the “sweet spot” for their investment risk. We refer to this space as the Risk Band. Simply put, the Risk Band clearly identifies where the investor wants to be and where they should be.
The third score is the risk score of the investor’s current portfolio, auto-populated by Totum and presented on the same line graph. Together, these 3 scores set the foundation for a healthy conversation between the advisor and their client regarding the right amount of investment risk for their portfolio.
As I mentioned before, ease and accuracy are just as important to the investor taking the questionnaire. To address this component, Totum shortened the questionnaire and incorporated machine learning as well as over 60 pages of PhD designed algorithms on the back end to provide results that are accurate enough to hold up in arbitration.
Hortz:Can you share with us the research and insights you uncovered that helped in building out your solution?
Shumbres: Totum spent a year researching risk tolerance before developing our product and there were numerous insights that helped shape Totum into the robust product it is today. Initially, we were going to score all risk metrics… risk capacity, risk appetite, constraints, probability, and more. Then we realized this would be too much for the investor to understand and for the advisor to explain to the client. As we continued our research, we found that risk capacity was the key component missing from other products on the market, yet was most pertinent to the client’s current life situation.
We also observed how giving a questionnaire only once further diluted its efficacy, especially if the questionnaire was based on the investor’s feelings about risk instead of facts that could impact their ability to take risk. Totum addresses this problem by sending an annual reminder to the advisor so they can reach out to their client and have them take the short questionnaire again. Not only does this ensure investments that are right for their client’s current life situation, it also strengthens the advisor/client relationship.
Hortz:Why do you feel your solution is, as you call it, an advisor’s insurance policy, and holds up to legal scrutiny better than other solutions?
Shumbres: We can fully document how we built in 60+ pages of quantitative risk models and are continuously adjusting our quantitative models based on new research and data to update and improve our scores. These models are managed by Steve Burns, PhD and his team of economic engineers who have 30 years of experience each in the financial industry. Its enhanced risk analysis based on facts, not just feelings.
When we brought our multiple scoring risk methodology to a number of SEC law firms to ask them how well our solution would hold up to legal scrutiny, they said, ‘Totum is the best we have seen in the industry and will help protect the advisor if they’re ever brought to arbitration.’ That’s a nice insurance policy!
Hortz:Are there any interesting applications or case studies that illustrate its competitive positioning with other similar tools?
Shumbres: As a fairly new risk tolerance tool to the market, our best case studies are advisors who convert to Totum Risk. So, let me have one of them answer that question for us. One recent quote from a Totum client said, ‘I LOVE the two different risk numbers (i.e. capacity vs. preference). This is a robust story and super meaningful for deepening the client conversation beyond what they initially say they are comfortable with.’
Hortz:Where is your R&D focused going forward? Any new technologies or applications coming down the pike we should be aware of?
Shumbres: We are constantly reviewing other technologies in the market to help improve Totum Risk and we believe the future of risk tolerance questionnaires will not be a questionnaire at all. Instead, risk scores will all be based on machine learning and AI (artificial intelligence). In the near future, an investor will be able to enter their name and phone number and automatically receive risk tolerance scores along with a narrative on how these scores were calculated.
Totum is already utilizing built-in machine learning that includes over 100 variables in our quant models. As we obtain additional data, our product can automatically update their risk scores, similar to FICO scores. As life events occur, we receive the information from multiple sources and their risk scores will be updated. If the portfolio drifts outside the Totum Risk Band, the advisor will receive an alert.
Totum is also focused on improving lead generation. Technology is changing the way advisors interact with their clients and 63% of investors are taking the risk questionnaire via a mobile device. We are exploring how to better capture and interact with this data and utilize the information for lead generation. We have developed a solution and will be launching this feature soon.
Hortz: From your perspective and experience, what best advice you can give advisors today about how to think about and manage risk for their clients?
Shumbres: Advisors often tell me, “I know my clients better than any risk tool.” Although this may be true in some cases, this methodology would not hold up in arbitration. Having current data on a client’s risk tolerance based on multidimensional scoring is not only a solid insurance policy for the advisor, it also provides a reason to reach out to their clients annually which reinforces their relationship and boosts client retention and referrals.
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