How to evaluate the customer’s risk tolerance

Most financial consultants are keenly aware of the importance of risk, but few financial terms are not clearly defined. Usually, consultants use questionnaires or quantitative tools to measure a client’s risk tolerance and meet regulatory requirements, but the reliability and actual implementation of these results vary from client to client.

The correct use of risk assessment can make you different.

What are we measuring?

FinaMetrica defines risk tolerance as the degree to which a customer chooses to risk less favorable results when pursuing more favorable results.More specifically, the organization believes that risk tolerance is mainly a psychological characteristic shaped by heredity and life experience.Measuring risk correctly involves looking at all these characteristics, rather than simply asking a set of general questions.

There are also different components to consider:

  • Risk tolerance: How much risk a customer is willing to take in pursuit of better returns.
  • Risk capacity: How much risk a customer can take without risking his goal.
  • Required risk: How much risk is needed to meet the client’s goals.

Financial advisers must consider the possible mismatch of these various forms of risk. For example, clients may have high risk requirements and low risk tolerance, which means their financial advisors may need to set more realistic return expectations. If financial advisors only consider risk tolerance when building a client’s investment portfolio, these insights will be completely ignored-clients may be disappointed with low returns.

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Objective third-party tools

When helping clients build investment portfolios, there are no rules or regulations that clearly stipulate how to measure risk. Typically, financial advisors use questionnaires designed to measure the risk tolerance of clients and equate the results with acceptable levels of volatility. An example is to ask the question, “If you lose 10% in the market adjustment, would you buy more, sell everything or stay the same?” and respond by adjusting the asset allocation.

Many customers do not understand their own risk tolerance, especially if they have not experienced a recession, or if they do not understand the impact of risk aversion on returns—especially if they have Experienced the recent economic recession. In addition, clients who are less familiar with financial terminology may have difficulty expressing their concerns and effectively communicating their risk tolerance to their advisors.

Although questionnaires are not necessarily a bad thing, financial consultants can improve the questionnaire by using objective third-party tools based on statistical data. Riskalyze.com is a good example of this type of software because it predicts the return of the investment portfolio based on risk and provides the probability that it aims to qualify the prediction. These types of tools can help clients imagine how risk affects their investment portfolio, rather than simply relying on questionnaire guesses.

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Some other popular risk assessment tools include:

Implementation survey results

Financial advisors must carefully implement these findings for clients while setting correct expectations and avoiding their own biases.

Most consultants have a much higher risk tolerance than their clients because they have a deeper understanding of statistics and the market. In fact, some studies have shown that, as a whole, financial advisors tend to create portfolios with higher risk than clients expect.If a market adjustment occurs, these dynamics may prove to be dangerous, because customers may not want to see the value of their portfolios be hit so hard.

Financial advisors should also set the right expectations from the beginning. By using advanced risk analysis software, it is easier to display a simulated investment portfolio to help in this regard, but it is still important to remind customers of the long-term nature of the market and the possibility of short-term fluctuations. Customers should understand that higher risk tolerance is equivalent to greater potential loss, and lower risk tolerance is equivalent to lower return potential.

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Finally, financial advisors must consider the differences in risk tolerance between partners and families. According to FinaMetrica data, most couples have significant differences in their risk tolerance, partly due to differences in risk-taking behaviors between men and women.Financial advisors should consider these dynamics when structuring their investment portfolio and work hard to ensure that both parties are satisfied with any decision.

Bottom line

Financial advisors are aware of the importance of risk, but few financial terms are defined as “risk”. It consists of three different elements and should be considered: risk tolerance, risk capability, and required risk. Targeted tripartite tools can help financial advisors to have a more comprehensive understanding of clients’ risk tolerance and at the same time help clients understand their risk profile. Finally, consultants should carefully implement this recommendation and do not let their own biases influence their decision-making.

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