Many clients have inaccurate perceptions of the amount of risk they can handle, putting the onus on you to help them determine their true risk tolerance.

“Clients overestimate the amount of risk they can take,” says Sajjad Hussain, vice president and private wealth counsellor with Fiduciary Trust Co. of Canada in Toronto. Advisors often have to adjust those expectations, he adds.

Clients often are unaware of the risks associated with various investment products, says Arthur Azimian, financial advisor with Edward Jones in Mississauga, Ont. They are typically willing to take on more risk when market performance is good, but become risk-averse when markets are volatile.

There are two aspects to risk: risk tolerance and risk capacity. Risk tolerance is based on clients’ emotional make-up and reflects how much risk they are willing to take. Risk capacity is the more empirical measure of the amount of risk clients can take based their circumstances such as age, income and net worth.

These four steps can help you arrive at an accurate risk profile:

1. Start with your client’s view of risk
The key is to ensure that you know your clients well, Azimian says. Ask questions to get to know as much about your clients as you can. There is usually a big difference between what clients say their risk tolerance is and their real risk tolerance.

To give you an indication of how your clients handle risk, get them to share their past investment experiences, and how they felt about them. For example, Hussain says, you might ask how they reacted to the financial crisis of 2008-09 and how it affected their attitude toward investing.

2. Look beyond KYC
The know-your-client (KYC) questionnaire usually is a good starting point toward gauging clients’ risk tolerance. But it is not sufficient to assess their risk profile. Although the KYC is a regulatory requirement that deals with variables such as client objectives, finances and time horizon, it does not address the psychological aspect of risk.

“Each client has a different risk profile, regardless of their age,” Azimian says. Therefore, he says, it is important to find out what they are trying to achieve.

3. Present various risk scenarios
Hussain recommends describing a variety of hypothetical situations to test your clients’ approach to loss. If you frame a question about potential loss in percentage terms, he says, clients tend to overestimate their risk tolerance. However, if you ask the same question expressing losses in terms of dollars, you would get a different answer.

For example, a client may say that he or she can tolerate a 20% loss on a $100,000 investment. But you would get a different answer if you asked whether the client would be able to tolerate a loss of $20,000 on the same investment.

4. Balance risk tolerance with risk capacity
A client with a high risk tolerance and a long time horizon may not have to take significant risk to achieve his or her investment goals, Hussain says.

Conversely, a client with a low risk tolerance and a short time horizon may need to take more risk to achieve his or her goals, depending on their unique financial circumstances.

Azimian asks five questions to clarify a client’s risk tolerance: Where are you today? Where would you like to be? Can you get there? How do you get there? How do you stay on track?