How do financial advisors choose client investments

Financial advisors are responsible for selecting the best investment for their clients. So, how do consultants get involved in the thousands of available products and build a product portfolio that suits you?

Key points

  • In order to choose investments for clients, financial advisors first evaluate investors’ risk tolerance and tolerance.
  • Most advisors use model portfolios, and they adjust to the needs and preferences of individual clients.
  • Clients should have a basic understanding of their advisor’s investment methods and compensation methods-the latter will affect asset selection.

Step 1: Assess the risk

Almost all consultants start from similar points. After the consultant determines the client’s risk tolerance, the portfolio selection is implemented. In other words, if the value of their investment portfolio declines, how will customers feel and react?

Closely related to risk tolerance is risk capacity: customers’ ability to withstand financial turmoil is measured by how long they have to retire, how much wealth they have, and their income.

Together, these two syndromes assess the risks that the client can handle. Although they often go hand in hand, they may be different. Clients may have sufficient resources to deal with market crashes (high risk capacity), but psychologically they are very painful to watch their asset value fall (low risk tolerance).

Finally, the consultant must understand the client’s goals. For example, Morgan may be in his sixties and is about to retire; they are mainly seeking capital preservation for their investment portfolios. Given that Alex is 30 years old; their goal is to buy a house, fund the child’s college education in ten years’ time, and save for retirement.

Build a portfolio

Once the consultant has created the client’s “risk profile” and determined the client’s goals, the asset selection process begins. Most consultants or consulting companies have various pre-determined “client portfolios”, also known as “model portfolios.” It is inefficient to build a new portfolio from scratch for each individual client. These client portfolios are based on the company’s investment policies and strategies; then they are combined with the specific needs of individual clients.

Morningstar, Inc. (MORN), Dimensional Fund Advisors and many other research companies provide financial advisors with back-end assistance in portfolios, especially if they are independent practitioners. For example, Morningstar provides tools to help consultants from start to finish. In addition to back-end assistance, they also provide consultants with methods to build, analyze, and monitor client portfolios. These tools come from asset class research. Individual consultants can even put their brand mark on a pre-selected Morningstar portfolio.

Then there are financial advisors enhanced by automated technology, sometimes called “robot advisors,” who make investment choices based on strategic algorithms.

Larger financial advisory companies—especially those that are active money management companies—usually have a research team or department that specializes in investment analysis and asset selection. These financial and research analysts also use a technique called alpha to help determine how far the realized return of the portfolio is from the return it should have realized.

Model combination strategy

Research supported by some investment consulting companies shows that it is very difficult to beat the market. Therefore, various styles of index fund products are created according to the risk profile of investors. For example, Dimensional Fund Advisors provides a series of low-cost funds (only sold through professional advisors) based on Nobel Prize-winning research on economists such as Eugene Fama, Kenneth French, and Myron Scholes.

Monte Carlo simulation is sometimes used to assist consultants in selecting client investments. The Monte Carlo model creates a statistical probability distribution or risk assessment for a specific investment. The consultant then compares the results with the client’s risk tolerance to determine the effectiveness of a particular investment. Running Monte Carlo models can create probability distributions or risk assessments for specific investments or events under review. By comparing the results with risk tolerance, managers can decide whether to proceed with certain investments or projects.

Bottom line

How an adviser chooses an investment portfolio is a different process, and it is best for investors to consult their specific financial adviser to understand how they make investment choices.

In addition, it is also important to ask your financial advisors how to get paid-because this may affect their choice of specific investments. Unless consultants pay as a percentage of assets or a fixed fee, they may have an incentive to choose products or product brands that pay higher commissions. The point is “possible”: Many commission-based financial planners assume fiduciary responsibilities and only recommend the most suitable tools and strategies for investors. Nevertheless, discussing how to choose assets at the beginning of the relationship will provide the best service to both the client and the consultant.


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