Financial Planning

Look beyond the KYC document and clients’ own claims of high risk tolerance

By Dwarka Lakhan |

Clients are usually uncertain about how much risk they can actually tolerate, putting the onus on you to determine their true risk profile.

"Clients almost always overestimate their level of risk tolerance," says Heather Holjevac, certified financial planner with TriDelta Financial Partners Inc. in Oakville, Ont. 

In addition, she says, clients are often fickle about risk. "When markets are going up," she says, "their risk tolerance is high. When markets are volatile, they become risk-averse."

So, getting a true reading of a client's tolerance to risk is a challenge. Here are four ways to determine an accurate risk profile:

1. Establish the client's investment time horizon

Your clients' investment horizon — whether it is short-term or long-term — will be a key determinant of your client's risk profile, Holjevac says. This piece of information helps you to establish the client's risk capacity — how much risk they can or should take — based their individual circumstances, such as age, income and net worth. Clients with a long time horizon do not necessarily have to take a lot of undue risk, Holjevac says.

If your client has a short investment horizon, your role will come down to determining whether he or she wants to take or can tolerate more risk to generate potentially higher returns to achieve their investment goals.  

2. Look beyond KYC
The "know your client" (KYC) questionnaire is a regulatory requirement for gauging clients' risk tolerance. However, it is not sufficient to fully assess their risk profile. KYC deals with variables such as client objectives and time horizon, but does not address the psychological aspect of risk.

"The KYC simply puts clients in pre-determined boxes — conservative, moderate and aggressive," Dally says. He recommends "digging deeper," using more informal methods. 

3. Understand your client's view of risk
"You have to know clients inside out to get an understanding of what risk means to them and how they will react to market movements," says Aiman Dally, CEO of Copia Financial Solutions in Toronto.

There is usually a big difference between what clients say their risk tolerance is and their actual risk tolerance. Get them to share their past investment experiences, Holjevac says. For example, they might have been emotionally devastated by investment losses in the past. Some clients, Dally says, may be inclined to get out of the market during a downturn. This information will provide an indication of your client's risk tolerance.

4. Present various risk scenarios
Holjevac recommends presenting various hypothetical scenarios, including a worst-case scenario, to gauge your client's appetite for the risk of loss. But note that the way you pose these questions can influence the answer.

If you frame a question about potential loss in percentage terms, clients tend to overestimate their risk tolerance. However, if you ask the same question expressing the loss in dollars, you might get a different, more conservative answer.

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