Risk and return are two fundamental factors that must be considered in analyzing any investment. All investors want to make the highest possible return from their investments. However, a potential return must always be balanced against potential risk. To analyze investments for individual clients properly, a financial advisor or money manager must create an accurate risk assessment, or risk profile, for each client. This risk assessment allows an advisor to determine the most suitable investments for each client to consider.

The Financial Elements of a Risk Assessment

Every risk assessment involves several key elements that can be used together to make up a broadly comprehensive analysis of the risk a client faces and the investments that best mitigate that risk or make the risk worthwhile.

The first element of a risk assessment is risk capacity, the maximum level of risk that an individual can afford to take based on his or her financial circumstances. This portion of the risk assessment is a quantification of the client's total ability to absorb a loss, whether the loss is small, moderate, or large. The capacity for risk also provides the advisor with an understanding of how the client's portfolio will function and the rate of change financially if a specific investment results in either a loss or a gain.

The second element of a risk assessment is risk requirement. Each client discusses his or her investment objectives with the advisor, and each advisor understands that a certain amount of risk is necessary to meet the investment return objectives that the client has in mind. The advisor then must determine what calculated investment risks must be taken to assist the client with meeting his or her investment goals successfully.

The Psychological Components of Risk Assessment

There are two key elements of a risk assessment that are not strictly financial concepts, but are more in the realm of psychological concepts. One such concept is the attitude to risk. Essentially, the attitude to risk is the client's understanding of risk in terms of what it entails and how it will affect the client's life and finances. Typically, a financial advisor further develops a risk assessment by determining the client's attitude toward risk at the outset, then reassessing the client's risk attitude after determining the client's risk capacity and risk requirements.

Risk tolerance is also a key psychological element of every risk assessment. Sometimes confused with risk capacity, risk tolerance differs in that it is the client's mental and emotional ability to tolerate chances taken on investments, given the level of risk, and how psychologically capable the client is at handling losses or overall volatility in both the short term and long term. Frequently, tolerance for risk highly correlates with previous investment experiences. Some clients have zero risk tolerance. They cannot deal with any sort of investment loss, not even a temporary one, no matter what the potential investment return is. For such clients, the only appropriate investments are fixed-income investments that provide a guaranteed rate of return and virtually no risk, such as U.S. Treasury bonds.

The Bottom Line

For a financial advisor to develop an accurate and effective risk assessment or profile, he or she must determine and assess each of the above-mentioned characteristics independently in order to compare them to each other and then combine them into a sensible investment risk level for a given client. Completing a risk assessment enables a financial advisor to determine general classes of assets and specific types of investments that are most appropriate for a given client. Both risk tolerance and risk capacity are constraints on potential investment returns, and advisors must make sure that their clients understand this fact.