Most financial advisors are keenly aware of the importance of risk, but there are few financial terms that are as poorly defined. Often, advisors use questionnaires or quantitative tools to measure a client’s risk tolerance and meet regulatory requirements, but the reliability and actual implementation of those findings vary between clients.
What Are We Measuring?
FinaMetrica defines risk tolerance as the extent to which a client chooses to risk experiencing a less favorable outcome in the pursuit of a more favorable outcome. More specifically, the organization considers risk tolerance to be a primarily psychological trait that is shaped by genetics and life experience. Properly measuring risk involves looking at all of these characteristics rather than simply asking a set of generic questions.
There are also different components to consider:
- Risk Tolerance: How much risk a client is willing to take in pursuit of better returns.
- Risk Capacity: How much risk a client can afford to take without risking his/her objectives.
- Risk Required: How much risk is necessary in order to meet a client’s objectives. (For more, see: Why Advisors Should Focus on the Emerging Affluent.)
Financial advisors must consider scenarios where these various forms of risk may be mismatched. For instance, a client may have a high risk requirement and a low risk tolerance, which means that his or her financial advisor may need to set more realistic return expectations. These insights would be entirely missed if a financial advisor looked only at risk tolerance when building a client’s portfolio — the client would likely be disappointed by the low returns.
Objective Third-Party Tools
There are no rules or regulations that specify exactly how risk is measured when helping clients build their portfolios. Often, financial advisors use questionnaires designed to gauge a client’s risk tolerance and equate the results to a certain level of acceptable volatility. An example would be asking questions like, “If you lost 10% in a market correction, would you buy more, sell everything or stay the same?” and responding by adjusting asset allocations. (For related reading, see: Are Millennials Risk Averse or Risk Takers?)
Many clients don’t understand their own risk tolerance, especially if they haven’t been through a recession or if they don’t comprehend the return impact of risk aversion—especially when they have been through a recent recession. In addition, clients that aren’t very familiar with financial terminology may have difficulty expressing their concerns and effectively communicating their risk tolerance to their advisor.
While questionnaires aren’t necessarily a bad thing, financial advisors can improve upon them by using objective third-party tools based in statistics. Riskalyze.com is a great example of such software as it projects returns for a portfolio based on risk and provides probabilities designed to qualify the predictions. These types of tools can help clients visualize how risk affects their portfolios instead of simply relying on the guesswork of a questionnaire. (For related reading, see: How Do Interest Rates Impact Risk Aversion in the Market?)
Some other popular risk assessment tools include:
Implementing the Findings
Financial advisors must carefully implement these findings for clients while setting the right expectations and avoiding their own biases.
Most advisors have a much higher risk tolerance than their clients, since they have a deeper knowledge of statistics and the marketplace. In fact, some studies have shown that financial advisors as a whole tend to create riskier portfolios than their clients desire. These dynamics can prove dangerous in the event of a market correction, when the client may not expect to see their portfolios take such a big hit in value.
Financial advisors should also set the right expectations from the start. By using advanced risk analysis software, it’s easier to show mock portfolios to help in this regard, but it’s still important to remind clients of the long-term nature of the markets and the potential for short-term volatility. Clients should understand that more risk tolerance equates to greater loss potential, while lower risk tolerance equates to lower return potential. (For related reading, see: What Kind of Securities Should a Risk-Averse Investor Buy?)
Finally, it’s important for financial advisors to consider differences in risk tolerance between partners and families. The majority of couples have a material difference in their risk tolerance, according to FinaMetrica data, driven in part by differences between male and female risk-taking behaviors. Financial advisors should consider these dynamics when building portfolios and work to make sure that both parties are happy with any decisions. (For more, see: How Advisors Can Help Clients Stomach Volatility.)
The Bottom Line
Financial advisors are aware of the importance of risk, but there are few financial terms that are as poorly defined as “risk," which is made up of three different elements that should be considered: risk tolerance, risk capacity and risk required. Objective third-party tools can help financial advisors gain a fuller picture of a client’s risk tolerance, while helping clients understand their risk profile. Lastly, advisors should carefully implement this advice without letting their own biases contribute to the decision-making. (For more, see: How Do Behavioral Economics Treat Risk Aversion?)