Tips for Assessing a Client's Risk Tolerance

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.

Conversations and perhaps the use of questionnaire can help the financial advisor asses the client’s 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.

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.

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.

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. Whatever these 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.

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. 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.

If the client is employed how stable is their job situation? While sometimes terminations and layoffs can be unexpected I’ve found that many people have a pretty good handle on their job security. Additionally, 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?

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.

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.

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.

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.

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.