One of the most important considerations in investing client money for a financial advisor is trying to assess the client’s risk tolerance. Risk can be defined in many analytical ways, but if you were to ask your clients their response would likely entail something along the lines of the risk of losing money.

As we learned during the market collapse of 2008-2009, many investors had over-estimated their ability to stomach downside risk and sadly many sold out of their equity holdings at or near the market’s bottom, suffering massive realized losses.

It's the job of the financial advisor to design an investment strategy for clients that balance their need for growth and takes into account their true appetite for risk. Here are a few thoughts on how to help clients assess their risk tolerance.

Key Takeaways

  • 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.
  • Subjective measures of risk include a client's personality, how they react to real or potential losses, and what their goals and priorities are.
  • Objective measures of risk are things like time horizon, age, the need for income, and family situation.

How Does the Client Define Risk?

Having pointed conversations and using a risk-profiling questionnaire can help a financial advisor asses clients' risk tolerance. It's particularly useful to get the client to talk about their feelings about risk and particularly about losing money. Often clients who are closer to or in retirement will feel more risk-averse, especially if their retirement resources are limited. For some people, risk is defined simply as market losses. For others, it may involve loss of a job, loss of income, or loss of insurance coverage. Yet others will frame risk in terms of opportunity costs - that is, the risk of missing out on a good investment.

Time Horizon and Financial Goals

In general, the longer a client can wait before needing their invested assets, the more risky their portfolios should be. This is because higher risk securities are compensated with a higher expected return, on average - and over longer time horizons, rough periods are often smoothed out. Also, clients can keep adding to their portfolios as markets dip (dollar-cost averaging), which means when the market begins rising again they've accumulated shares at better prices.

Typically, a time horizon of 10 years or longer until the client needs to tap into their money would indicate that they could take a bit more risk as they would have time to recover from the inevitable market corrections that occur. Less than 10 years would indicate that the portfolio allocation should dial back a bit on risk as there is less time for the client to recover from a volatile market. As a result, older clients who may be retiring soon should often be weighted more to generally less risky bonds, while younger workers can have much more allocated to stocks.

Factoring in Possible Emergencies

It's important to determine if the client has sufficient liquidity so they won’t have to dip into their investments to cover living expenses and other normal ongoing expenses during the time horizon in which the money is to be invested. If it's likely they will need to dip into the funds to be invested for the long-term, it would be wise to encourage them to invest less and leave some of the money on the side in less risky vehicles.

Usually, advisors recommend around 5% of portfolio assets allocated to cash or money market funds. This way, when an emergency does strike, that can easily be drawn upon. However, cash earns only the risk-free return and therefore too much can be a bad thing, causing cash-drag that can lower overall returns over time.

Investment Preferences

Does the client have any particular investment preferences that need to be considered when designing their portfolio? Perhaps they inherited certain stocks that they are reluctant to sell them. This is known as the endowment effect - it is objectively irrational to treat such gifted stock as special, but the emotional links should not be ignored. Instead, they should be accommodated.

Whatever these client preferences are they should be taken into account when suggesting an asset allocation to your clients so that their portfolio is not over or under allocated to one or more areas based upon these preferences.

Sources of Retirement Income

For clients closing in on retirement, financial advisors should take a look at all sources of their client’s retirement income in assessing the appropriate risk level for their portfolios. At retirement, the goal is no longer to grow assets in the market; rather, it is to generate income from those accumulated assets.

For example, if a client has a pension as well as Social Security these might be viewed as fixed streams of income allowing the client to allocate a bit more than they might otherwise to equities.

Factoring the Client’s Work Situation

If the client is employed how stable is their job situation? While sometimes terminations and layoffs can be unexpected, many people have a pretty good handle on their job security. If job security is tenuous, a lower risk assessment is necessary as a client may need to rely on investment funds to hold them over until a new job opportunity appears.

Additionally, ask about what is the nature of the client’s income? Is it a stable salary with some sort of bonus? Is their income variable and based primarily on commissions which can fluctuate? The more stable it is, the more risk they can potentially take in the market.

Weighing the Client's Family Situation

Is the client married? Do they still have kids living at home? Do they have a child with special needs or who otherwise requires their support? This will all play into their cash flow needs both now and down the road.

If children are in the picture, the risk situation may become a bit nuanced. Perhaps life insurance is necessary in case something dreadful happens. College planning will also divert assets from other purposes to a 529 account.

Reaction to Last Major Market Decline?

The financial crisis of 2008-2009 and the resulting extreme decline in the stock market was the ultimate test of risk tolerance for any investors. The news media wrote many stories of investors who just couldn’t stomach their investment losses any longer and who sold out of equities at or near the bottom of the market. Sadly, many of these investors realized massive losses and then missed out on all or much of the ensuing Bull Market for stocks.

Risk Tolerance Can Change Over Time

Certainly, as clients age and approach retirement they will often become more risk-averse. Additionally, life events and other developments may trigger a change in a client’s tolerance for risk.

An example might be an unexpected layoff as a client nears retirement. This is sadly not uncommon in the corporate world and losing a few years of expected employment and retirement savings might have a devastating impact on their retirement. This might cause them to become more averse to losing money.

Couples with Differing Risk Tolerances

Just because a couple is happily married, it doesn’t mean that they each have an identical tolerance for risk. In fact, many financial advisors tend to have experience working with couples where each spouse has a different risk tolerance. The key here is to understand where each spouse is coming from and to help them reach their financial goals via an investment allocation that will allow both of them to sleep at night.

The Bottom Line

Determining the client’s risk tolerance is a critical piece of the puzzle in designing an appropriate asset allocation that will both allow them to achieve their financial goals and to sleep well at night. Risk tolerance is as much “art” as science, and in order for a financial advisor to assess it they must really get to know and understand their clients.