By 

J.B. MAVERICK

June 3rd, 2024

As a financial advisor, it's essential to tailor your clients' portfolios to their goals and comfort level with risk. Not doing so could lead to unnecessary stress, anxiety, and potentially devastating losses.

Every client is different. Some wealthy individuals may be reluctant to take chances, while those with fewer assets may be eager for a wager aimed at high returns. It's your job to assess their psychological comfort with risk and create a portfolio that aligns with their needs and reflects their finances.

"Psychological components play a large factor in clients' tolerance toward risk," Nate Creviston, manager of wealth management and portfolio analysis at Capital Advisors in Shaker Heights, Ohio, told us. "Simply put, some are more comfortable taking risks if they know that mathematically, over long periods, they will outperform others who aren't comfortable taking on risks. However, clients who are risk-averse aren't wrong. They deserve to have a portfolio tailored to their comfortability and goals."

KEY TAKEAWAYS

• Financial advisors need to recommend investments that align with the client's willingness and ability to take on risk.
• Risk tolerance considers aspects of a client's personality, background with money, how they handle losses, goals, and priorities.
• Risk capacity evaluates their income, time horizon, age, future income needs, and family situation.
• Questionnaires or surveys can help financial advisors create a risk assessment for each client.
• Higher returns are associated with higher risks, making risks inescapable in investing.

An appropriate portfolio should derive from the investor's willingness (risk tolerance) and ability to take on (risk capacity) hazards in the market. Investors must also understand the nature of the risks and the possible consequences. By taking the time to understand your client's risk tolerance, you can create a portfolio that helps them sleep better at night while still working toward their financial objectives.

Understanding Risk Tolerance

In finance, risk is the likelihood that an investment's outcome will differ from the expected returns. When creating a portfolio, investors and their financial advisors should understand the risks associated with each asset.

While risk is inherent to the market, not all risks are created equal. For example, fixed-income instruments such as bonds are generally safer than equities, but a blue chip stock may be less risky than a poorly-rated junk bond.

Below is how U.S. investors described their risk tolerance, according to a 2023 Financial Industry Regulatory Authority report.

Risk Tolerance and Risk Capacity

Risk tolerance is often confused with risk capacity, mainly because they are related, though distinct concepts. Risk capacity is your ability to handle financial losses. Generally speaking, the more wealth you have, the greater your risk capacity. Risk tolerance is related to your willingness to wager in the market—do you need a sure thing before putting money on the table, or are you a bit devil may care about the odds?

This will be related to your risk capacity since your risk tolerance will typically change how much you will put at stake and how much of a hazard you consider it to be to your financial well-being. Losing a few hundred dollars could be devastating to someone living paycheck to paycheck, far less so to someone worth millions.

Experience and Risk Tolerance

"Risk tolerance is a very capricious thing," said David Demming, a 40-plus-year financial advising veteran and president of Demming Financial Services in Aurora, Ohio. "It's only mitigated by experience," that is, knowledge of the regular volatility of the market.

How To Assess a Client's Risk Tolerance

Risk tolerance refers to the client's mental and emotional ability to handle risk or the level of uncertainty they can withstand without it causing stress and anxiety. Advisors must respect and align their recommendations with the client's comfort level.

Several factors influence risk tolerance, including age, financial stability, and investment goals. For example, a young investor with a stable income and long-term investment horizon may be more willing to take on higher risk for potentially higher returns. Meanwhile, an older investor nearing retirement may prioritize capital preservation and have a lower risk tolerance.

The opposite of risk tolerance is risk aversion. If an individual would rather miss out on potential gains than take the chance of losing money, that client is relatively risk-averse. In contrast, a risk-seeking client desires the highest possible return and is willing to endure significant portfolio fluctuations to achieve it.

Advisors often use surveys to gauge clients' risk tolerance. "Questionnaires are a great starting point for understanding a client's ability to handle risk and attitudes around investment risk. An open discussion about what thoughts came up as they were taking the assessment usually adds the necessary context required to settle on the right allocation for a client," said Eric Kimbro, a certified financial planner with Stone Kimbro in Costa Mesa, California.

Creviston, too, noted the importance of getting the client to speak more expansively on this topic. "We use a few metrics to help define a client's risk tolerance, but the main method we use is open conversation. We believe a lot is missed if the client is only filling out a questionnaire that puts them into one of five categories," he said. Creviston suggested that it's not enough to obtain a measure of their tolerance, but why it's at the level it is. "You might miss that their risk-averse attitude comes from a family event that left them unable to tolerate risk, you might miss that they’ve taken a lot of risk in the past, but have lost a lot of money due to red flags being ignored," he said.

Risk Capacity

Li Tian, a financial advisor in San Marcos, California, isn't afraid to go deep with her clients to get the best understanding of their risk tolerance. "I've found face-to-face (or via video conference) conversations with the clients, about their situation, families, even their relationship with money growing up, can help me to discover important nuances that a simple questionnaire would not be able to capture." It also provides, she said, "a better understanding of their history … and can help me to confirm (or lean sideways) from their baseline questionnaire conclusions. Their history might also shine a better light on their psychology that they may not be aware of themselves."

The other side of the coin is risk capacity, or the ability to take on risk without endangering the client's long-term goals. This is far easier to measure than risk tolerance and can be determined by the amount and type of assets in a client's portfolio.

Risk capacity depends on a client’s potential need for liquidity (quick access to cash) and how quickly they need to meet their financial goals. It can be assessed through a review of assets and liabilities. An investor with many assets and few liabilities has an elevated ability to take on risk. Conversely, an individual with few assets and high liabilities has less of an ability to take on risk.

However, a client's risk capacity isn't proportional to their risk capacity. "Even if [clients] have a large risk capacity but a low-risk tolerance, they might never feel comfortable when their portfolio drops more than 20% during a bear market," Creviston said.

Many times, a client might be used to certain assets that provide habitual types of returns. "We often have clients with significant amounts of private real estate holdings, for example, and no need to take on excess public market risk. It’s important to tailor a customized portfolio to this type of client knowing that they can count on a certain dollar amount each year coming from rent payments," Creviston said. "This isn’t the case in the public markets. We can count on an average 10% return in the S&P 500 over 10-year rolling periods, but the volatility year to year differs from a lot of other asset classes our clients might be exposed to."

Factors That Drive a Client's Risk Tolerance

Many people have risk tolerances that are sui generis—it's unique to them and hard to explain given their background and present finances. Still, for most people, you can identify certain factors or drivers influencing their willingness to take on investment risk. Here are the most important:

• Age and time horizon: Younger investors normally have a longer time horizon, which allows them to take on more risk since they simply have more time to recover from potential losses. As people draw closer to retirement, they prefer less risky investments to preserve their capital.
• Income and finances: Clients with a stable and high income are usually more comfortable taking on higher risks since they have a reliable source of funds.
• Financial obligations: High debt or financial responsibilities (e.g., mortgage, education expenses, young children) often reduce a client's risk tolerance.
• Investment experience: Experienced Investors are more likely to understand market volatility and thus may be more comfortable with higher-risk investments. In addition, clients with successful investment histories may be more willing to take risks. Meanwhile, those who feel snake bitten—they have had significant losses—may be more cautious and risk-averse.
• Personal attitudes: This is a catchall for differentiating those whose personalities are the primary driver of risk tolerance, not metrics about their income, etc. For example, risk-seeking individuals enjoy the excitement of taking risks and are more likely to invest in assets that meet that for them. Risk-averse people prefer stability and prefer conservative investments to avoid losses.
• Investment goals: Clients aiming for significant portfolio growth may be willing to accept higher risk for those potential rewards. Clients focused on preserving their existing capital will prefer lower-risk investments.
• Market conditions: During rising or bull markets, clients may feel more confident and willing to take on more risk. In fact, economists like Hyman Minsky have argued that it's endemic to the capitalist system that people generally take on more risk as a bull market goes on, leading to the boom and bust cycles that have plagued economic history. The opposite is also the case, which is why Minsky argued for the government to compensate for the lack of demand in the broader economy when the market was falling. In declining markets, clients are very often more risk-averse and seek safer investments.
• Liquidity needs: Clients needing quick access to their funds are less likely to take on high-risk investments that may be illiquid or volatile. Those without those needs may be more comfortable with less liquid, higher-risk investments.
• 
  

Financial advisors can better understand their clients' risk tolerance by considering these factors and providing tailored strategies that align with their clients' profiles and goals.

Types of Risk

The most familiar types of risk are those that can be measured directly. For example, the probability that a winter storm will affect shipping or crop yields can be reliably calculated, based on previous events.

Other risks are harder to quantify: there is no reliable way to measure the chance that lawmakers will pass a new trade restriction or that equities will enter a bear market. Still, even an imperfect understanding of these dangers can help investment professionals choose the best assets for their clients.

Liquidity Risk

The following are some sources of risk and common mitigation strategies:

Liquidity risk refers to the danger that the client may need to cash out their assets at short notice. This is not always a necessity, but most investors still find it comforting to know that they are able to cover sudden or unanticipated costs.

Liquidity risk varies among different investments. For example, a financial advisor may advise private equity investments for clients who are less concerned with fast access to cash, allowing the potential for significantly higher returns. Meanwhile, clients concerned about liquidity would benefit from investments in exchange-traded funds (ETFs) and large-cap stocks that can readily be liquidated for their fair market value.

Market Risk

Market risk is the threat that asset prices will fall, either because of declining investor expectations or as part of a wider downturn. The dot-com bubble in the late 1990s and the Great Recession after 2008 are classic examples of market risk since even highly rated stocks suffered from plunging prices.

Market risk can be mitigated by diversifying one's portfolio, especially among assets that are not correlated. This does not eliminate market risk, but it makes it less likely that all the assets in a portfolio will decline at the same time.

What Are the Risks of Employing a Financial Advisor?

While investment advisors are strictly regulated, there are concerns that some financial advisors may not have their client's best interests in mind. For example, some advisors may earn a commission from selling certain investments, or they may be paid on a per-trade basis—giving them a monetary incentive to recommend trades that may not be warranted. In other cases, an advisor may provide good advice that does not justify their high fees. These concerns can be allayed by considering a fee-only advisor or researching the background of your advisor and ensuring they are a fiduciary.

What Is Risk Management in Finance?

Managing risk involves identifying, measuring, and reducing the uncertainties associated with investing. Risk is an inescapable part of finance since the highest returns come with the greatest risks. By learning more about the risks associated with a particular investment, an advisor can determine if that investment is suitable for a specific client's risk assessment.

What Are the Least Risky Investments?

Historically, fixed-income securities like government and highly rated corporate bonds tend to have the lowest risk. However, these also tend to have lower returns than other assets. While equities tend to outperform bond markets, they are also riskier. This risk can be somewhat mitigated by investing in passive index ETF rather than individual stocks.

The Bottom Line

Understanding a client's risk tolerance is crucial when tailoring your investment advice. Factors driving risk tolerance include age, income stability, investment experience, and personal attitudes toward risk. Market conditions, economic environment, liquidity needs, and psychological factors also play significant roles.

To assess a client's risk tolerance and risk capacity, advisors should talk openly with their clients to uncover these underlying drivers. This not only helps in crafting a suitable investment plan but also builds trust and confidence in the advisor-client relationship. By prioritizing an understanding of risk tolerance, advisors can better navigate market fluctuations and economic uncertainties, guiding clients toward achieving their long-term financial objectives with greater peace of mind.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.

SEE IMPORTANT DISCLOSURES IN LINK