Experienced financial advisors understand that the field of financial planning reflects a shifting mosaic of theoretical models, particularly when it comes to gauging risk.
In Explaining Risk to Clients: An Advisory Perspective, a recent paper commissioned by the Pension Research Council, part of the Wharton School at the University of Pennsylvania, advisors Paula Hogan and Rick Miller outline several planning frameworks and argue in support of a comprehensive approach that focuses more closely on the value of human capital – the net present value of lifetime earnings.
In the traditional planning model, advisors focus on investment risk. In determining how much risk to recommend to a client, advisors would assess whether the client can accept or afford that threshold (sometimes called “risk capacity”), as well as his or her level of comfort with asset price volatility.
The traditional advisor usually holds a strong belief in both the long-term advantage of stocks over bonds and in reversion to the mean for stock returns.
In line with this thinking, such advisors view portfolio management as a key, if not the core deliverable. These advisors believe their clients also evaluate them on this basis, the authors note, and speak about those who have “done well” or “done poorly.”
As a result, because stocks are deemed less risky in the long run, boosting the client’s stock exposure to improve the odds of meeting financial goals is seen as prudent. However, this perception is skewed, given the advisor’s belief that stocks actually are not all that risky in the long run anyway.
Although this traditional approach may have been adequate in the past, the study’s authors suggest that it is time for a revamped paradigm: “Specifically, we believe that advisors are shifting away from providing mainly portfolio management [and] toward the role of financial counsellors who facilitate a process designed both to define and support client financial safety and well-being.”
Using a more comprehensive approach, advisors orchestrate a self-discovery process in which clients identify specific preferences about who they are, what they want to do with their lives and how much risk they can assume.
This approach requires greater emphasis on tailoring the financial portfolio’s level of risk to the client’s human capital. The more volatile or uncertain the client’s career, everything else being equal, the greater the stability and lower the risk the client will require in his or her portfolio.
Shifting the planning spotlight from investments to expected lifetime earnings and potential changes in the income stream then becomes the fulcrum for a more realistic financial plan.
Using this revamped approach, the plan more accurately reflects consumption over time and across contingencies throughout the client’s life. As a result, the investment risk taken should correspond closely with the volatility of the client’s earned income. As the client’s ability or willingness to earn income declines over time, there typically is a commensurate need to reduce portfolio risk.
This emphasis broadens the scope of the advisory engagement, the study’s authors say, focusing more attention on understanding and managing the client’s career path, protecting earned income with appropriate disability and life insurance, and tailoring financial risk to the expected risk and return of the human capital.
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