Risk and return are two fundamental factors that must be considered in analyzing any portfolio or investment. All investors want to make the highest possible return from their investments; however, a potential return must always be balanced against potential risk. Indeed, the greater the expected return, often the greater the level of risk involved for a potential loss.
To analyze investments for individuals 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, taking into consideration both a client's objective capacity as well as subjective willingness to take on risk.
- Investing necessarily involves a certain element of risk that can lead to losses.
- Building a portfolio and making investment recommendations must be tailored to an individual's risk profile, obtained through a risk assessment.
- This evaluation will obtain both the objective or financial aspects of risk as well as the psychological or qualitative components of risk tolerance.
- When the ability to take risk is at odds with an investor's willingness for risky investments, it is good practice to go with the more conservative evaluation.
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 their 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.
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.
The second element of a risk assessment is risk requirement. Each client discusses their 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 their investment goals successfully.
The Psychological Components of Risk Assessment
There are two further elements of a risk assessment that are not strictly objective financial concepts, but are more in the realm of psychology.
The first such concept is risk attitude. 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.
The second is risk tolerance. Sometimes confused with risk capacity, risk tolerance differs in that it is the client's mental and emotional ability, or willingness to tolerate chances taken on investments. It starts with a given the level of objective risk, but then evaluates 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, they 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.
In the event that an investors' capacity and willingness to take risk are at odds with one another, it is a good rule of thumb to go with the more conservative assessment.