Techniques for assessing customer risk tolerance

One of the most important considerations for a financial advisor to invest in client funds is to try to assess the client’s risk tolerance. Risk can be defined through a variety of analytical methods, but if you ask a customer, their answer may involve the risk of losing money.

As we learned during the market crash of 2008-2009, many investors overestimated their ability to withstand downside risks. Sadly, many investors sold their holdings at or near the bottom of the market and suffered A huge realized loss.

The job of a financial advisor is to design investment strategies for clients to balance their growth needs and consider their true risk appetite. Here are some ideas on how to help clients assess their risk tolerance.

Key points

  • As a responsible financial advisor, you should always make appropriate investments for your clients based on their willingness and ability to take risks.
  • Subjective measures of risk include the personality of the customer, their response to actual or potential losses, and what their goals and priorities are.
  • Objective measures of risk include time frame, age, income needs, and family status.

How do customers define risk?

Conducting targeted dialogues and using risk analysis questionnaires can help financial advisors assess the client’s risk tolerance. It’s especially useful for customers to talk about their feelings about risk, especially loss of money. Generally, customers who are about to retire or are about to retire will be more risk-averse, especially when their retirement resources are limited. For some people, risk is simply defined as market losses. For others, it may involve unemployment, loss of income, or loss of insurance coverage. Others construct risk based on opportunity cost—that is, the risk of missing a good investment.

Time frame and financial goals

Generally speaking, the longer a client waits before needing to invest in an asset, the greater the risk of their investment portfolio. This is because higher-risk securities receive higher expected returns on average—and in a longer time frame, difficult times are usually smoothed out. In addition, as the market drops (USD cost averaging), customers can continue to increase their portfolio, which means that when the market starts to rise again, they accumulate stocks at better prices.

Normally, a time frame of 10 years or more before the client needs to use the funds indicates that they can take more risks because they will have time to recover from the inevitable market adjustment. Less than 10 years will indicate that portfolio allocation should reduce risk, because customers have less time to recover from a turbulent market. Therefore, older customers who may be about to retire should generally pay more attention to lower-risk bonds, while younger employees can allocate more to stocks.

Consider possible emergencies

It is important to determine whether the client has sufficient liquidity so that they do not have to spend the investment within the time frame of the investment to pay for living expenses and other normal ongoing expenses. If they may need to invest money in long-term investments, it is wise to encourage them to reduce investment and keep some of the funds in lower-risk instruments.

Typically, consultants recommend that approximately 5% of the portfolio’s assets be allocated to cash or money market funds. In this way, when an emergency does happen, it can be easily used. However, cash can only earn risk-free returns, so too much can be a bad thing, causing cash drag, and reducing overall returns over time.

Investment preference

Do clients need to consider any specific investment preferences when designing their investment portfolio? Maybe they have inherited some stocks they don’t want to sell. This is the so-called endowment effect—it is objectively unreasonable to treat this kind of genius stock as special, but the emotional connection should not be ignored. Instead, they should be accommodated.

Regardless of these customer preferences, you should consider them when suggesting asset allocation to your customers so that their portfolio will not be allocated to one or more areas based on these preferences.

Retirement income source

For clients who are about to retire, financial advisors should look at all sources of their clients’ retirement income to assess the appropriate level of risk in their investment portfolio. At retirement, the goal is no longer to increase market assets; instead, it is to generate income from these accumulated assets.

For example, if a client has pensions and social security, these may be seen as a fixed income stream, allowing the client to allocate more stocks than otherwise.

Consider the client’s work situation

If the client is employed, what is their job status? Although sometimes terminations and layoffs may be unexpected, many people have a good grasp of their job security. If job security is weak, a lower risk assessment is required, because customers may need to rely on investment funds to maintain them until a new job opportunity arises.

In addition, ask what is the nature of the customer’s income? Is it a stable salary and some kind of bonus? Is their income variable and based mainly on commissions that may fluctuate? The more stable it is, the greater the risk they may take in the market.

Weigh the customer’s family situation

Is the client married? Do they have children living at home? Do they have a disabled child or other child who needs their support? All this will satisfy their cash flow needs now and in the future.

If there are children in the photo, the risk situation may become a bit subtle. Maybe life insurance is necessary in case something terrible happens. University planning will also transfer assets from other uses to 529 accounts.

Reaction to the last major market decline?

The 2008-2009 financial crisis and the resulting extreme decline in the stock market are the ultimate test of investors’ risk tolerance. The news media have written many stories about investors who can no longer afford investment losses and sell stocks at or near the bottom of the market. Sadly, many of these investors realized the huge losses and then missed all or most of the subsequent stock bull market.

Risk tolerance will change over time

Of course, as customers age and approach retirement, they usually become more risk-averse. In addition, life events and other developments may trigger changes in the customer’s tolerance for risk.

An example might be accidental layoffs when a client is approaching retirement. Unfortunately, this is not uncommon in the corporate world, and losing years of expected employment and retirement savings can have a devastating effect on their retirement. This may make them less willing to lose money.

Couples with different risk tolerance

Just because a couple is happily married does not mean that each of them has the same risk tolerance. In fact, many financial advisors often have experience working with couples, each of whom has a different risk tolerance. The key here is to understand the source of each spouse and help them achieve their financial goals through investment allocation so that both of them can sleep at night.

Bottom line

Determining the customer’s risk tolerance is a key part of designing appropriate asset allocations that will enable them to achieve their financial goals and get a good night’s sleep. Risk tolerance is as “art” as science, and in order for financial advisers to evaluate it, they must truly understand and understand their customers.


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