One of the most important tasks for a financial advisor is assessing a client’s risk tolerance. As we learned during the market collapse of 2008-2009, many investors overestimated their ability to stomach downside risk and rushed to sell their stocks at or near the market’s bottom, suffering massive losses.
Risk can be defined in many ways, but if you were to ask your clients they would likely respond that they are, of course, averse to losing their hard-earned money. The question is how determined they are to avoid risk in return for potentially greater rewards.
It’s the job of the financial advisor to design an investment strategy for clients that balances their need for growth while taking into account their true appetite for risk.
- As a responsible financial advisor, you should always put your clients in suitable investments that correspond with their willingness and ability to take on risk.
- Objective measures of risk are factors such as the individual’s time horizon, age, need for income, and family circumstances.
- Subjective measures of risk include the client’s personality, their reaction to real or potential losses, and their long-term goals and priorities.
How Does the Client Define Risk?
For some people, risk is defined simply as the potential for market losses. For others, it may involve the risk of losing a job, losing income, or losing insurance coverage. But others will frame risk in terms of opportunity costs. There’s a risk of missing out on a good investment.
Asking pointed questions and using a risk-profiling questionnaire can help a financial advisor assess a client’s risk tolerance. It’s particularly useful to get the client to talk about their feelings about risk and particularly about losing money.
Clients who are retired or close to retirement are likely to be more risk-averse, especially if their retirement resources are limited.
Time Horizon and Financial Goals
In general, the longer a client can wait before dipping into invested assets, the riskier a portfolio can and should be. Higher-risk securities generally have a higher expected return, and over longer time horizons, the rough periods are often smoothed out.
In addition, clients with a longer time horizon can keep adding to their portfolios during market dips. This strategy of dollar-cost averaging allows them to accumulate more shares at better prices.
Typically, a time horizon of 10 years or longer indicates that a client can take a bit more risk. Less than 10 years would suggest taking a bit less risk, as there is less time for the client to recover from a downturn.
As a general rule, the portfolio of older clients who may be retiring soon should be weighted more to less risky assets like bonds, while younger workers can tolerate greater exposure to stocks.
Factoring In Emergencies
It’s important to determine if clients have enough liquidity that they won’t have to cash in investments to cover living expenses during the time horizon in which the money is to be invested.
If it’s likely they will need to dip into funds that are being invested, it would be wise to invest less in long-term assets and leave some money on the side in low-risk accounts or cash.
Advisors generally recommend that around 5% of portfolio assets be allocated to cash or money market funds. These can easily be drawn upon for an unexpected expense. Too much cash will lower overall returns over time.
Does the client have any particular investment preferences that need to be considered when designing their portfolio?
Many have a particular industry or sector that they follow closely. Others have political or ethical concerns about some companies or industries.
Some may have inherited certain stocks that they are reluctant to sell. This is known as the endowment effect. It is objectively irrational to treat them as special, but emotional links should not be ignored.
Whatever these client preferences are they should be taken into account when suggesting an asset allocation so that their portfolios are not over or under-allocated to one or more areas based upon personal preferences.
Sources of Retirement Income
For clients closing in on retirement, a financial advisor must take a look at all sources of income in assessing appropriate risk levels. After retirement, the primary goal is not to grow assets but to generate income from accumulated assets.
For example, if a client has a pension as well as Social Security these should be viewed as fixed streams of income that allow the client to allocate a bit more to stocks than they might otherwise.
Factoring the Client’s Work Situation
A job loss or layoff can happen to anyone but most people have a pretty good handle on their job security. If it’s tenuous, a lower risk assessment is necessary. The client may need to rely on investment funds until a new job opportunity appears.
There are other questions to ask about the client’s income. Is it a stable salary or a variable income that is dependent on commissions? The steadier the income, the more market risk a person can take on.
Weighing the Client’s Family Situation
A client who is married and has children has responsibilities that must be addressed. Their short-term needs for cash and their long-term investing goals both are factors in their investing strategies.
If young children are in the picture, the risk profile must reflect that. Life insurance is necessary in case the worst happens. Some savings will need to go into a 529 account for their educational needs.
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 investors. There were many stories of investors who just couldn’t stomach their investment losses any longer and who sold out of stocks at or near the bottom of the market. Others, it must be said, held on and prospered handsomely.
Sadly, many of these investors realized massive losses and then missed out on all or much of the following historic bull market. They wished their money had been in AAA-rated bonds, and maybe it should have been.
Risk Tolerance Can Change Over Time
As clients grow older they typically become more risk-averse, and for good reason. Their life circumstances demand a more cautious approach to investing.
A worst-case example might be an unexpected layoff as a client nears retirement. Losing a few years of expected income and savings can have a devastating impact on retirement. The possibility causes some people 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.
The key is to understand both viewpoints and help them reach their goals via an investment allocation that allows each of them to sleep at night.
What Factors Determine an Investor’s Risk Tolerance?
Risk tolerance is a mixture of circumstances and psychology.
A person’s circumstances include family makeup and other responsibilities as well as age, career stage, and long-term goals.
Psychology is harder to determine. When stocks tank, some investors grit their teeth and wait for tomorrow. Others blame their financial advisors for getting them into bad choices.
What Is the Average Risk Tolerance in Investing?
A person with a moderate risk tolerance might go for a 50/50 investment split between large-company mutual funds and very low-risk bonds. Such investors are not chasing the next Google. They’re investing for the long term and have put half their money in funds with a reasonable chance of good growth.
Even a person with a moderate risk tolerance may change strategies over time. As a person approaches retirement age, a more cautious approach is wise. There might not be time to recover from a financial setback.
What Is Low Risk Tolerance in Investing?
People with a low risk tolerance might also be called conservative investors. They do not want to risk their principal. They want their nest eggs in highly-rated bonds and liquid investments like bank certificates of deposit (CDs) or Treasury securities.
What Is High Risk Tolerance in Investing?
Those with a high risk tolerance go for the big bucks, regardless of the very real chance of big losses. They go for stocks with high growth potential, search out new and untested sectors, and may even double down on the risk by buying on margin.
The Bottom Line
Determining the client’s risk tolerance is critical to designing an appropriate asset allocation for a client’s portfolio. Risk tolerance is as much art as science. In order to assess it, a financial advisor must get to know and understand each client.