Picking clients is harder than picking stocks

When talking to fund managers and wealth managers, you will inevitably hear about the difficulty in communication between finance professionals and (retail) investors. Too often clients are disappointed by the performance of an investment even though the fund manager thinks she has explained all the risks in great detail. Clients then often blame the fund manager while the fund managers tend to blame the clients. Or as one fund manager summarised it: “Picking clients is harder than picking stocks”.

A study by researchers from Austria and Sweden examined the interplay between retail clients and financial professionals when investment decisions are delegated to professionals. The clients had different risk profiles and thus requested portfolios with different risk levels. To simplify things, clients could request one of four different risk profiles and financial professionals could then construct portfolios based on these risk levels. The chart below shows the outcome of that exercise. For each risk level, the share of portfolios by actual risk (measured by the arguably imperfect measure of the standard deviation of returns) is given.

True vs. desired risk level of delegated portfolios

Source: Stefan et al. (2022)

Several things stand out. First, the variation in portfolio volatility varied widely for each risk level. In fact, some portfolios in risk levels 1 and 2 had a volatility that puts them squarely into the highest risk level 4. Second, even if we ignore the outliers, there is still a significant overlap between adjacent risk levels. In other words, if a client asks for risk level 2, she will likely get anything between risk level 1 and 3.

This isn’t necessarily the advisers’ fault. The study showed that advisers take a lot of effort to match the risk profile of the portfolio they construct for clients to the requested risk profile. But two factors complicate things. First, clients have their own minds and ask for individual twists and tweaks that may change the overall risk profile of the portfolio. Second, because of the different levels of expertise in investments, what an investor may find risky a client may not (e.g. cryptocurrencies) and vice versa (e.g. equities for long-term investors). The result is that a substantial minority of financial professionals feel the portfolios they have created for clients are in fact riskier than the requested risk level.

Obviously, that is bad news for clients if financial advisers are able to make better decisions than retail investors. But as I have shown here, they are, on average, not able to do that. The emphasis is on the words “on average” because the Austro-Swedish study cited above also looked at the investment decision making quality of advisers and clients and found that for low to medium risk portfolios, financial professionals are no better than clients, while for high-risk portfolios, financial advisers do show better investment decision-making capabilities. It’s just that very few clients want such high-risk portfolios and even fewer are willing to let an adviser have free rein. The end result is that clients and financial professionals both end up with portfolios that often do not match a client’s ability and willingness to take on risks. And the result is that both parties are unhappy with the results.