When developing a solid investment portfolio for an individual client, a financial advisor must take into consideration key factors that help craft the most suitable investment strategy. Ultimately, the primary concern is the achievement of the client’s financial goals, and key considerations are the client's willingness and ability to take risks in order to obtain those goals. There are numerous fundamental aspects intimately woven into these concerns, which every financial advisor must examine before building a sound portfolio.
Willingness and ability to take risk may not always match up. For example, the individual in the example above with high assets and low liabilities may have a high ability to take on risk, but may also be conservative by nature and express a low willingness to take on risk. In this case, the willingness and ability to take risk differ and will affect the ultimate portfolio construction process. A suitable investment one that is appropriate in terms of an investor's willingness and ability (personal circumstances) to take on a certain level of risk. It is essential that both these criteria be met. If an investment is to be suitable, it is not enough to state that an investor is risk friendly. They must also be in a financial position to take certain chances. It is also necessary to understand the nature of the risks and the possible consequences.
- As a responsible financial advisor, you should always be putting your clients in suitable investments that correspond with both their willingness and ability to take on risk.
- Risk tolerance measures subjective aspects of risk tolerance, including a client's personality, how they react to real or potential losses, and what their goals and priorities are.
- Capacity or ability to take on risk measures objective factors like time horizon, age, the need for income, and family situation.
- Other issues related to risk stem from liquidity and tax situations that advisors should be aware of when computing overall riskiness of a portfolio.
Risk tolerance is often confused with risk capacity, but the reality is that while the two are similar and related, the two concepts are quite distinct from each other. Perhaps the simplest way to understand the two is to consider them as opposing sides of the same coin.
When a financial advisor deals with a client’s risk tolerance, the advisor is determining the client’s mental and emotional ability to handle risk. Essentially, this aspect of risk management is understanding and respecting the level of investment or financial risk that a client is comfortable taking, or the degree of uncertainty that the client can withstand without losing sleep. Typically, the level of risk that a client deems acceptable will vary with their age, financial stability and security, and the investment goals that the client wants or needs to achieve. Advisors sometimes utilize questionnaires or surveys to get a better grasp on how risky an investment approach should be.
Willingness to take on risk refers to an individual's risk aversion. If an individual expresses a strong desire not to see the value of the account decline and is willing to forgo potential capital appreciation to achieve this, this person would have a low willingness to take on risk, and is risk averse. Conversely, if an individual expresses a desire for the highest possible return, and is willing to endure large swings in the value of the account to achieve it, this person would have a high willingness to take on risk and is a risk seeker.
The other side of the coin is risk capacity, or the ability to take on risk. This is more of an objective financial numbers game. The financial advisor must review a client’s portfolio, taking into account financial metrics that indicate the level to which the client’s bottom line can withstand risk in the event of potential losses, and compare this with how potentially beneficial the risk is in terms of possible capital gains. Risk capacity is constrained by several aspects and involves a client’s potential need for liquidity, or quick access to cash, along with how quickly the client needs to meet their financial goals.
The ability to take risks is evaluated through a review of an individual's assets and liabilities. An individual with many assets and few liabilities has a high ability to take on risk. Conversely, an individual with few assets and high liabilities has a low ability to take on risk. For example, an individual with a well-funded retirement account, sufficient emergency savings and insurance coverage, and additional savings and investments (with no mortgage or personal loans) likely has a high ability to take on risk.
Liquidity risk is often a major source of concern for clients. The ability to quickly sell off assets and liquidate them into cash is not always a necessity, but most investors still find it comforting to know that they have the ability to cover sudden or unanticipated costs, such as a medical emergency. The risk lies in the types of investments the client holds. For example, a financial advisor may advise private equity investments for clients who are less concerned with fast access to cash, with the tradeoff being the potential for significantly higher returns. On the other hand, clients concerned about liquidity would benefit from investments in exchange-traded funds (ETFs) and stocks, which are investments that can readily be liquidated for their fair market value.
Tax Concerns for Investors
A financial advisor must also determine how to construct a client’s investment account properly, based on any tax concerns that the client may have. This is largely based on the client’s time horizon and investment goals.
For example, consider that a client is building up an investment account to save for retirement and wants to defer tax payments on the client's investments until the time that the client retires. Most clients prefer to defer taxes until retirement because they will generally fall into a significantly lower tax bracket then, due to far less income being earned than was the case during their active working life. For a client in this situation, the best course of action that the financial advisor can take is to set up investments through a vehicle, such as a Roth IRA account, which generally allows withdrawals that are tax- and penalty-free after the client reaches age 59 1/2. However, for clients who anticipate making frequent withdrawals of investment capital prior to retirement, there is no benefit from making investments through a tax-deferred type of investment account.