How Financial Advisors Pick Client Investments

Financial advisors are charged with choosing the best investments for their clients. So how does the advisor wade through the thousands of available products and choose a portfolio that’s right for you?

Almost all advisors start from a similar, client-focused point. Portfolio selection is implemented after the advisor determines a client’s risk tolerance. In other words, how will the client feel and react in the event that his or her investment portfolio drops in value?

More recently, risk capacity is also addressed. Risk capacity refers to the client’s ability to weather financial storms as measured by how much time they have until retirement, how much wealth they have, and their income. These types of factors influence how much risk a client is able to handle. A client may have sufficient resources to handle a market crash (high-risk capacity) yet psychologically be very distressed watching the value of his or her assets fall (low-risk tolerance). 

Next, the advisor must understand the client’s goals. For example, is Ryan nearing retirement and looking mainly for capital preservation? Whereas, Michelle is age 30 with many years until retirement. She needs to fund for her children’s college expenses, buy a home and retirement.

Once the advisor creates a client ‘risk profile’ and ascertains the client’s goals, then the asset selection process begins. Most firms have a variety of predetermined ‘client portfolios.’ It would be inefficient to build from scratch a new portfolio for each individual client. These client portfolios are based upon the firm’s investment policy and strategy. They are integrated with the particular needs of the individual clients.

Morningstar, Inc. (MORN), Dimensional Fund Advisors, and many others provide portfolio back-end assistance to financial advisors. In fact, there are likely as many ways to pick clients' investments as there are advisors.

Morningstar, the well regarded independent research firm offers a product for financial advisors. They provide tools to help advisors from start to finish. Along with back-end help, they have ways for the advisor to construct, analyze, and monitor client portfolios. These tools are informed by asset class research. The individual advisors can even put their brand stamp on pre-selected Morningstar portfolios.

Other firms have an independent research team devoted to asset selection. This team of well-educated investment researchers look for ways to improve alpha over strict indexing approaches. Then there are the automated technology enhanced financial advisors, sometimes referred to as ‘robo-advisors’ who also have theories upon which they base their investment choices. Jemstep, in particular, licenses its platform to financial planners for use under the advisor's brand. 

Then there are the investment advisory firms who support research which suggests that it’s very difficult to ‘beat the market’ and therefore create index fund offerings in various flavors, depending upon the investor’s risk profile. Dimensional Fund Advisors offer a low fee assortment of funds sold only through advisors. Their portfolio of funds is based upon Nobel Prize winning research of Fama, French and Scholes and translates this highly regarded research into investment funds available through financial advisors.

Monte Carlo simulations are sometimes used to assist advisors in selecting client investments. The Monte Carlo model creates a statistical probability distribution or risk assessment for a particular investment. The advisor then compares the results against the client’s risk tolerance to determine the efficacy of a particular investment. Running a Monte Carlo model creates a probability distribution or risk assessment for a given investment or event under review. By comparing results against risk tolerances, managers can decide whether to proceed with certain investments or projects.

How advisors choose investment portfolios is varied, and investors are wise to check with their particular financial planner to find out how he or she makes their investment choices. Additionally, it’s important to understand that there may be an issue with asset selection. Unless the advisor is paid as a percent of assets or with a flat fee, the advisor has an incentive to choose higher commission investments for the client. The client and advisor will be best served by discussing how assets are selected at the outset of their relationship.